One of the fundamental duties of a fiduciary is to control and account for a client's investment fees and expenses. This particular responsibility has become the focus of most of the regulatory changes now under consideration in Washington, and also has been the primary cause of participant lawsuits against larger 401(k) plans.
Many people think a fiduciary must select the lowest-cost service provider or lowest-priced basket of goods and services. Not so. Instead, a fiduciary must be able to demonstrate the thought process behind a choice. A fiduciary must be able to show what the costs are for, how the costs compare to other options, who has been compensated from the client's account and whether that compensation was fair and reasonable.
A number of people also think that the use of proprietary- or commission-based products is an inherent fiduciary breach. Again, not so. Existing fiduciary acts, such as ERISA, do not contain blanket prohibitions against the use of such products. However, these products are subject to the same procedural prudence requirements as any other product or service suggested by the fiduciary and will certainly raise a red flag with auditors, compliance officers, regulators and litigators. For this reason, financial providers may decide to prohibit such products as a way to mitigate risk.
A CHECKLIST FOR EXPENSES
What is the best way to manage your fiduciary duty to control and account for investment expenses? The following procedural checklist can help:
* Provide a written agreement. The SEC requires you to provide each client with a written agreement defining your services, fees, forms of compensations and any conflicts of interest. When ERISA 408(b)(2) goes into effect on Jan. 1, 2012, advisors working with 401(k) plans will also have to disclose compensation and source of compensation.
* Use revenue-sharing accounts properly. Revenue-sharing accounts, when appropriate, must be used only to pay for authorized investment-related expenses. Of course, you cannot parlay your position of trust for personal profits. Therefore, any compensation you receive for asset placement, such as a 12b-1 fees, must be applied for the exclusive benefit of the client. As I have reported in previous columns, newly proposed regulations may have an impact on 12b-1 fees, and advisors who rely heavily on such compensation models should consider moving to an asset-based fee model.
* Weigh costs and benefits of different risk management strategies. Prudent diversification is a cost-effective way to manage portfolio risk, and software may demonstrate that adding investments improves the client's returns or lowers risk. But the gains must outweigh any associated costs. For example, making small allocations (less than 5%) to a client's investment strategy is likely to raise costs without providing a material change to the client's risk/return profile; the unwarranted additional costs could give rise to a fiduciary breach.
* Weigh costs and benefits of active versus passive investment strategies. Choosing actively managed funds over ETFs and index mutual funds may be appropriate, but only if you can demonstrate that the typically higher costs are reasonable for your client.
* Weigh the costs and benefits of separate account managers versus mutual funds. Many separate account managers have lowered their minimums, but a separate account isn't necessarily the best choice even for clients who qualify. Still, fiduciaries must examine the pros and cons of the two investments.
For example, mutual funds spread their costs across all shareholders-a good thing if your client has a small investment in the mutual fund, a potentially bad thing if your client has a large investment. The taxable client, particularly one with low-basis stock, will likely fare better with a separate account manager who can provide a tax-sensitive investment strategy.
The fund manager is also disadvantaged in that he or she must contend with purchases and liquidations within the fund. This can be a major problem in a down market when the investing herd tries to move out of a fund, forcing the manager to sell securities against his or he better judgment.
* When using separate account managers, monitor best execution. The SEC requires money managers to seek best execution in trading a client's account, but it's still prudent for you to check as well. Some clients may have inadvertently signed directed brokerage or commission recapture agreements that excuse the manager of this duty. A simple monitoring tactic: Check if one or two brokerage firms are getting most of the money manager's trades.
* When using separate account managers, monitor soft dollars. Soft dollars are the excess commissions generated from trading a client's account. If a money manager is trading a client's account at more than four cents per share, the account is likely to be generating soft dollars and you should talk personally to the money manager about how the soft dollars are being utilized. Under SEC guidelines, soft dollars can be applied to buy securities research. But soft dollars are still a source of abuse and need a close eye.
* Compare a fund's or money manager's fees and expenses to peers. When you select an investment option, you should compare the cost of a manager, index or ETF within a peer group or investment style-for example, small-cap managers compared with other small-cap managers. If 75% of the group costs less than your choice, you could be vulnerable to a charge that you didn't properly account for your client's expenses as a fiduciary.
Some money managers say that their performance will absorb higher fees. It may have been true in the past, but how do you know it will be true in the future? Remember that you will be judged as a fiduciary by your decision-making process-not the outcome.
* Maintain liquidity. The market downturn in 2008 made everyone conscious that any money a client may need within five years should be in cash or high-quality unleveraged bond investments. Raising cash in a crisis can be expensive.
* Be sure your service provider can monitor costs. Problems arise when a service provider is unwilling to disclose fully the breakdown of all fees and expenses associated with a client's account. Under such a scenario you may have little alternative than to seek a different provider.
* Ensure asset-based fees are appropriately applied. Whenever asset-based fees are involved-whether the fees are being paid to you, a money manager or the custodian-you should ensure that fees have been accurately calculated and applied to a correct account balance. It's not uncommon to discover different service providers calculating a different account balance for the same client. When this occurs, it often is because the client's account includes individual bonds, some of which are not priced on a daily basis.
* Watch for conflicts. As a fiduciary, you need procedures to monitor whether other service providers are using their position of trust for personal profit-for example, by accepting compensation for placing assets with a particular provider-or have engaged in any other prohibited transactions. Be alert for any signs that a firm isn't ethical.
MONITOR YOUR PRACTICE
At least annually, assess whether you're fulfilling your duties as a fiduciary. Your role is to stay informed about changes in the industry. Given the current regulatory focus on fees and expenses, for example, you should have a checklist to monitor them, including the details I've outlined here. Remember: Your duty goes beyond knowing what costs your clients are incurring. You must diligently and reliably watch that your clients' money is being spent well.
Donald B. Trone is CEO and founder of Strategic Ethos and founder of the Foundation for Fiduciary Studies.