As the SEC engages in the rule-making associated with its proposed uniform fiduciary standard of conduct under the Dodd-Frank Act, it likely will focus its attention on an advisor or broker's duty of loyalty and duty of care.
* Loyalty. Regulators will consider whether rule-making should prohibit certain conflicts. They also will determine whether to require firms to mitigate conflicts through specific actions, or to impose specific disclosure and consent requirements.
* Care. Regulators will consider specifying minimum professional standards, such as what basis an investment advisor or broker-dealer should have in making a recommendation to an investor.
Of the two, the duty of loyalty will garner most of the rule-making attention. This is where broker-dealers have the greatest concern about triggering prohibited transactions. Questions that arise include: Can a broker providing advice to a retail client offer access to an IPO? Can a broker execute a principal trade on behalf of a retail client or sell proprietary products? (Commission-based products already have received relief under the Dodd-Frank Act.)
On the other hand, rule-making on the duty of care will probably be minimal, with the SEC continuing its long-standing tradition of allowing the industry to define the details of what constitutes baseline professional standards and industry best practices.
The baseline we'll use as a fiduciary benchmark was created from existing standards that apply to trustees, investment committee members and advisors who manage the decisions of pension plans, personal trusts, foundations and endowments. These standards are all substantiated by existing legislation, regulatory opinion letters and bulletins, and case law.
Fiduciary standards are based on principles as opposed to rules; these principles serve as best practices that help define a prudent investment process. These principles are easy to implement and communicate to clients and other service providers. As principles, they can be modified and adjusted to accommodate the unique requirements and objectives of each client.
My organization has defined two fiduciary standards, one based on a five-step decision-making process and the second on a six-step financial planning process. We'll use the six-step process since the differences are minimal. We'll discuss the first three steps in detail and the rest in an upcoming issue.
It's also worth noting that a traditional financial planning process largely mirrors a fiduciary decision-making process - not a surprise since both are based on a simple, logical, hierarchical approach. This should ease planners' concerns since the SEC's proposed uniform fiduciary standard of conduct, if properly defined, should be consistent with planners' existing practices.
Let's start our benchmarking by defining the six steps to the fiduciary standard. To illustrate the consistency between a fiduciary standard and the financial planning process, I've added the comparable financial planning process to each step.
* Step 1 - Define. Establish the relationship with a client.
* Step 2 - Analyze. Gather and categorize client data.
* Step 3 - Strategize. Analyze and evaluate a client's financial status.
* Step 4 - Formalize. Develop and present recommendations.
* Step 5 - Implement. Move forward with recommendations.
* Step 6 - Monitor. Track action.
To ensure all parties are in sync, each service provider's responsibilities should be in writing. This enables a planner to delegate with confidence and lets those empowered to act without hesitation.
Definitive objectives must be established. The financial planner plays a key management role in ensuring that a client's goals and objectives are articulated and communicated clearly.
These objectives must be realistic and consistent with estate planning documents, the client's health and current assets and associated financial position (liens, loans and liquidity requirements). They must also reflect personal considerations, the client's view toward wealth and be aligned with his or her values, and philanthropic and legacy interests.
A planner plays the most critical role in this fiduciary decision-making process because he or she manages the process. But what role will other professionals play, and are they aware of their responsibilities? There must be full disclosure of all regulations and trust laws that may impact a client's plan. Successful investment professionals have many different approaches, but all develop clear strategies and apply them consistently. This discipline is the defining behavior of all great investment managers.
Analyzing risk is an important concern among clients. Risk can never be avoided completely, but it can be managed through the proper implementation of a sound decision-making process.
The term risk has different connotations, depending on a client's frame of reference, circumstances and objectives. Typically, the investment industry defines risk in terms of statistical measures such as standard deviation. However, such measures may fail to adequately communicate the potential negative consequences an investment, or governance, succession planning or other strategy, can have on the ability of a client to meet stated goals.
Risks are not only financial risks, they also include any impediment to the accomplishment of a client's goals. Poor health can destroy the best-laid plans, and time taken away from family to create wealth can create gaps in life's fulfillment.
A planner's role is to decide which of a client's assets, optimally allocated, will produce the greatest probability of achieving stated goals. The process begins by taking an inventory of assets: liquid (cash reserves and other funding sources), illiquid, business and human capital (for founders, often the most valuable asset). How these are deployed requires a thorough knowledge of:
* All assets, including their availability and usefulness;
* Available choices and options;
* The risk/reward ratio of deploying (or not deploying) certain assets; and
* Redeployment and rebalancing as a situation changes.
Another critical role a planner plays is to help ensure a portfolio has sufficient liquidity to meet obligations when they come due. A planner should prepare a cash flow statement that shows anticipated contributions and disbursements for at least five years. This analysis is essential to determining the time horizon of investment portfolios.
Identifying a horizon for each client goal often is the key variable in determining the allocation between equity and fixed income - between liquid and illiquid assets. As a general rule, time horizons of less than five years should be implemented with cash and fixed income, while longer time horizons should mean allocations across a broad range of asset classes. Even if a client has a high risk tolerance, a planner should not direct an investment into equities if the money is required in the next year.
Expected outcomes may differ from a client's goals in that they represent quantifiable results expected over a shorter time horizon. For example, an expected outcome may be for an investment strategy to produce a total rate of return that exceeds the rate of inflation by a certain amount, or to have sufficient liquidity to pay estate taxes due.
Coming next: how to formalize and implement recommendations - and monitor the outcome.
Donald B. Troneis CEO and founder of Strategic Ethos and founder of the Foundation for Fiduciary Studies. He is the co-author, with Charles A. Lowenhaupt, on the forthcoming book, Freedom From Wealth.