There are various stories in the investment/financial services press regarding alleged hardships that financial firms and advisers are facing in trying to prepare for the DOL’s recent announcement of its new fiduciary rule and the accompanying Best Interest Contract exemption (BICE). Other are complaining about the alleged cost of creating compliance systems, while others are selling all or part of their existing business.
In my honest opinion, as a former compliance director and now a ERISA/securities/ fiduciary attorney and compliance consultant, the claims of hardship simply have no merit and can be seen as an admission that many of the current investment products and services offered by the investment/financial services industry are not prudent and cannot meet the prudence/best interest requirements under any fiduciary standard. And yet, the evidence clearly shows that there are products and services that could meet such requirements if the industry was willing to invest the time and effort to identify same.
Since there is a reasonable expectation that any fiduciary standard adopted by the SEC will closely track the DOL’s new fiduciary rule, I will use the DOL’s new rule and BICE as a beginning point. In adopting its new fiduciary rule, the DOL requires that any advice being provided to “Retirement Investors” be in the “best interest” of the Investor. (1) In defining “best interest,” one of the nation’s top ERISA attorneys, Fred Reish correctly points out that the DOL essentially adopted ERISA’s fiduciary duties of prudence and loyalty.(2) The DOL’s new fiduciary rule tracks ERISA’s Section 404(a)’s prudent person standard requiring that the advice provided be in the best interest of the investor, with
such care, skill, prudence, and diligence under the circumstance then prevailing that a prudent persona 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,…(3)
Equally important is the DOL’s acknowledgement that BICE’s principle-based conditions are based on the law of trusts and agency to ensure that financial advisers and institutions always put a client’s interests first.(4) With this admission and the fact that the courts and regulators generally rely on the Restatement of Trusts in deciding fiduciary issues, a review of the Restatement’s relevant provisions provides a blueprint for financial advisers and institutions in designing a due diligence process to ensure compliance with the new and anticipated fiduciary rules.
Section 90 of the Restatement (Third) of Trusts, commonly known as the Prudent Investor Rule (Rule), is the key section of the Restatement with regard to prudent investing. Not surprisingly, ERISA is largely based on the Rule. Two consistent themes throughout both ERISA and the Rule are the fiduciary duties of being cost-conscious(5) and effectively managing investment risk, primarily through effective diversification.(6)
In addressing a fiduciary’s duty to be cost-conscious, the Restatement and the Rule specifically require that fiduciaries address the extra costs and risks associated with actively managed mutual funds and active management strategies, including the increased trading costs associated with same.(7)
Because the difference in totality of the costs [of funds] can be significant, it is important for [fiduciaries] to make careful overall cost comparisons, particularly among similar products of a specific type being considered for an [investment] portfolio.(8)
Trustees, like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and cost for a particular level of expected return- or, inversely, the highest return for a given level of risk and cost.(9)
In short, both the Restatement and the Rule require fiduciaries to determine whether the extra cost of an actively managed mutual fund or investment strategy can be justified by realistic expectation of a commensurate level of return to cover such additional cost. Based on the historical evidence of past performance of actively managed funds and strategies, the “woe is me” cries coming from the investment/ financial services industry and the sale of financial companies, either in whole or part, are overreactions and, in effect, a realization and admission by the industry that a significant portion of their current products and/or service platforms cannot consistently meet these cost-conscious and “best interest” fiduciary requirements.
There is a general agreement in the legal community that variable annuities (VAs) will be a primary target of litigation under the DOL’s new fiduciary rule and BICE. This opinion is based largely on the high, imprudent and inequitable expenses generally associated with most of the current versions of VAs.
One of the primary expenses associated with VAs is the annual maintenance and expenses charge (M&E charge), which supposedly covers the cost of providing the VA’s death benefit. As of September 2016, Morningstar was reporting that the average annual M&E charge for VAs was 1.25 percent. The key issue with the M&E charge is the fact that most VA issuers use a method known as “inverse pricing” to calculate the annual charge, or pricing the charge on the accumulated value of the VA instead of the actual cost to the VA issuer to provide the death benefit.
The use of the “inverse pricing” method ensures that the VA issuer will receive a substantial windfall at the VA owner’s expense. A famous study found that in most cases, the M&E charge was often ten times, in some cases 20-30 times, greater than its fair value.(10) Since fiduciary law is based primarily on trust law and equity law, and equity abhors a windfall, the use of “inverse pricing” in assessing VA M&E charges is a clear violation of a fiduciary’s duties of prudence and loyalty, requiring that a fiduciary act solely in the client’s “best interest.”
Each additional 1 percent of fees and other investment costs reduces an investor’s end return by approximately 17 percent over twenty years. Morningstar reported that as of September 2016, the average combined annual expense ratio and subaccount fees for VAs was 2.25 percent. This would equate to an estimated 38 percent reduction in an investor’s end return over twenty years.
VA salesmen usually try to get VA buyers to purchase additional features, or “riders,” that provide benefits such as guaranteed minimum death benefits or other “living benefits” such as guaranteed rates of return. Morningstar reported that as of September 2016, the costs for such riders could easily increase a VA’s cumulative fees to 3.5-4 percent, which would equate in a 60-68 reduction in an investor’s end return over twenty years.’ Obviously any investment that ensures that an investor would lose 50-60 percent of their end return is neither prudent or in an investor’s “best interest.”
The prudence/“best interest” issue also applies to actively managed mutual funds. Standard and Poor’s SPIVA reports have consistently reported that 70-80 percent of actively managed mutual funds underperform comparable passively managed, or index, mutual funds. The good news for financial advisers and financial institutions is that these numbers show that there are actively managed mutual funds that do provide alpha, do outperform similar passively managed mutual funds.
The question then is how can financial institutions and advisers protect their practices and provide value added services to clients by identifying such actively managed funds? Several years ago I created a metric, the Active Management Value Ratio 2.0 (AMVR). The AMVR is a simple cost/benefit metric that allows investors, financial advisers and attorneys to determine the cost efficiency of an actively managed mutual fund.
The AMVR is based on the studies of two investment icons, Charles Ellis and Burton Malkiel. The AMVR uses an actively managed fund’s incremental return, if any, and incremental costs, which includes both a fund’s annual expense ratio and turnover/trading costs, to determine a fund’s cost efficiency.
Interpreting a fund’s AMVR score is simple and straightforward. If a fund fails to provide any positive incremental return, or the fund’s incremental costs exceed the positive incremental produced by the fund, then the fund is obviously imprudent and not in an investor’s “best interest” since an investor would lose money by investing in the fund. For more information about the AMVR and instructions on calculating the metric, click here.
As outlined herein, the investment/financial service’s “woe is me” cries of hardship in connection with the DOL’s new fiduciary rule and BICE simply have no merit, and are arguably an admission that many of the investment products and services that they have been recommending all this time are, and have been, imprudent and not in the “best interest” of investors. The industry’s argument regarding the supposed hardship in complying with the DOL’s rule and BICE, as well as the adoption of a similar fiduciary standard by the SEC also has no merit, as the NASD, FINRA and regulatory enforcement actions have consistently stated that brokers and broker-dealers have always had a duty to act in a customer’s “best interest.(11)
The cries of financial hardship in complying with the new fiduciary rules is either meritless or an admission that the broker-dealers have been out of compliance in supervising the trading activity of their brokers who operate through an independently owned RIA firm. In NASD Notice to Members 94-44, the NASD officially stated that broker-dealers had a duty to supervise the trading activity of brokers affiliated with such independent RIAs. In supervising the activity of brokers affiliated with such independent RIAs, or for that matter their own internal RIA, broker-dealers would have been required to supervise such activity under a fiduciary prudence/”best interest” standard since it is well-established that RIAs and investment advisory representatives are fiduciaries.
As for specific products, most VAs, in current form, will never pass any fiduciary standard unless and until their fees are restructured to only charge prudent and equitable fees and other expenses. While studies have consistently shown that the overwhelming majority of actively managed mutual funds fail to outperform comparable passively managed mutual funds, those same studies establish that there are actively managed mutual funds that would satisfy applicable fiduciary standards.
The AMVR provides a free and simple method of identifying such funds, thereby allowing financial institutions and financial advisers with the opportunity to provide their customers with true valued-added services while protecting their practices. The only question is whether such financial institutions and financial advisers will take the small amount of time and effort required to do so.
1. 29 C.F.R. §§ 2509, 2510 and 2550
2. Fred Reish, “Best Interest Contract Exemption: Interesting Angles on the DOL’s Fiduciary Rule #15,” available online at http://fredreish.com/interesting-angles-on-the-dols-fiduciary-rule-15/
3. 29 C.F.R. §§ 2509, 2510 at ¶¶ 21007, 21077 and 21083
4. 29 C.F.R. §§ 2509, 2510 and 2550 at ¶ 21007
5. Restatement (Third) Trust § 88 cmt a, cmt b
6. Restatement (Third) Trust § 90
7. Restatement (Third) Trust § 90 Introductory Note to § 90, cmt h(2), cmt m
8. Restatement (Third) Trust § 90 cmt m
9. Restatement (Third) Trust § 90 cmt f10. Moshe Milevsky, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1 (2001) 91-126, 94
11. FINRA Regulatory Notice 12-25 (May 2012)