Best Practices for the Selection and Monitoring of Investment Service Providers


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Blaine F. Aikin, CEO of fi360, presented this topic during the 2013 Ball State Foundation PAC Seminar.

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  • Now that we have covered why the new rule pertaining to 408(b)(2) was introduced and how the disclosure is to be used, let’s think about how you will benefit by using the disclosure information to help fulfill your fiduciary obligation to select service providers wisely.First, you can reduce your risk of having an adverse regulatory action if your plan is audited by the DOL. And, if an unhappy participant attempts to assert a claim that the investments of the plan are not performing as well as they should have, it is important to be able to demonstrate that the service providers were properly selected. Thus, by complying with 408(b)(2) requirements, you can reduce litigation risk.Second, by using a prudent selection process you are more likely to find well qualified service providers who will do a better job of delivering the services you want at a competitive price. You can think about this in the same way you would about picking an attorney, doctor, veterinarian or even a home improvement contractor: the more homework you do to select that service provider, the happier you are likely to be with the outcome.Third, careful contracting necessarily involves giving careful thought to the services you need and who will be providing them. As you saw from the sample client services agreement I showed you, a well designed agreement is specific about roles and responsibilities. This helps avoided confusion or misunderstandings about who is doing what and it helps to make sure that everything that needs to be done is assigned to qualified people.Finally, and most importantly, by strengthening your own fiduciary processes and picking service providers with strong capabilities, the participants and beneficiaries of your retirement plan are likely to be well served. This is the concept of fulfilling the duties of loyalty and due care by applying processes that demonstrate fiduciary excellence.As I said earlier, a knowledgeable advisor can help you navigate your fiduciary duties more effectively, including helping you to understand the disclosures and activities of other service providers.[Speaker note: Adjust your narrative for this slide and others in the presentation to be sure that what you say is aligned to what you do. If you do not intend to assist in the selection of other service providers or in helping the steward to navigate their fiduciary duties you will not want to represent that you will do so in the course of this presentation. Additionally, be clear in your client services agreement as to the services you are going to provide and, as a best practice, identify services that you don’t intend to provide if you think there could be a misunderstanding between you and the client without specific referring to tasks that are beyond the scope of your engagement.]
  • This chart compares characteristics of product originators, traditional brokers, and advisers, as they relate to the consumer or client. For a financial planner who both develops planning recommendations and assists the client in implementing the recommendations and monitoring the plan, the planner must be aware of the obligations of other ‘team’ members and their qualifications.     A product originator or manufacturer is generally a counter party to a sale. When dealing directly with the product originator, the onus is on the buyer to determine whether a product is suitable. A product originator, like a broker, operates in a rules-based environment. The product originator and traditional broker are often in a manufacturing or sales role, respectively, and are not fiduciaries.  The traditional broker is an agent of his or her company with a duty of loyalty to act in the interest of a brokerage firm, not the client. A broker may also serve in a more neutral role in facilitating a transaction or providing other administrative or custodial services, such as a discount broker. If you are wondering how the traditional broker acting in an agency capacity can also be required to ensure that a product is suitable for the customer, then you’ve identified one of the dynamic tensions inherent in the non-fiduciary role.     A suitability standard owed to a customer mitigates part of the duty of loyalty a transactional broker owes to his or her firm. Yet a suitability standard does not require the broker to act solely in the customer’s best interest, as long as the product is suitable. This gray area of the law is often lost on investors, and many assume the agent is acting on their behalf. These divided loyalties between the firm, the customer, and the broker’s own interest can be difficult to manage.    For example, if a broker recommends buying shares in a proprietary mutual fund – one that results in a higher commission to the broker ― although a conflict of interest exists, the broker is not in violation of any regulation as long as the investment is suitable for the client.  A suitability requirement does not impose a continuing duty of care or disclosure of conflicts of interest, unless required by rule. Parties held to a suitability standard may still choose to act in the best interest of the client and disclose conflicts of interest. But, if taken to arbitration or court, the agent’s defense counsel would almost always object to a breach of fiduciary duty. In contrast, a fiduciary must make recommendations that are in the best interest of a client. The fiduciary must follow an extensive due diligence process and weigh reasonable alternative strategies or products to assist the client in meeting his or her goals and objectives.  The absence of explicit suitability rules for registered investment advisers is a good example of principles-based regulation. If a fiduciary duty requires the adviser to act in the client’s best interest, it follows that an investment recommendation must be suitable, even though that is not explicitly addressed by law or regulation.  In the case of the broker, the suitability requirement ends with the execution of the transaction, and there is no ongoing duty to monitor. The adviser's obligation to monitor ends only when the agreement itself is terminated.
  • Best Practices for the Selection and Monitoring of Investment Service Providers

    1. 1. Best Practices for the Selection of Investment Service Providers Blaine F. Aikin, AIFA®, CFA, CFP® CEO, fi360 © 2013 fi360 Inc. All Rights Reserved. 2
    2. 2. Topics • The fiduciary standard as the basis of procedural prudence • A process-driven approach to due diligence • Service provider selection generally • Investment due diligence Note: We will reference the Prudent Practices Handbook for Stewards during this discussion 3© 2013 fi360 Inc. All Rights Reserved.
    3. 3. Duties Associated With the Fiduciary Standard Fiduciary Standard Duty of Loyalty Avoid/Manage Conflicts Disclosure Proxy Policy Principal Trades Suitability Both Duties of Loyalty and Care Best Execution Reasonable Fees & Expenses Duty of Care Safeguard Client Assets, Privacy Procedural Prudence Due Diligence Monitoring Record- Keeping 4© 2013 fi360 Inc. All Rights Reserved.
    4. 4. Global Fiduciary Precepts 1. Know standards, laws, and trust provisions. 2. Diversify assets to specific risk/return profile of client. 3. Prepare investment policy statement 4. Use “prudent experts” and document due diligence 5. Control and account for investment expenses 6. Monitor the activities of “prudent experts” 7. Avoid conflicts of interest and prohibited transactions
    5. 5. Establishing “Reasonable” Service Provider Relationships • A service agreement isn’t reasonable if you don’t know the service provider’s – services – compensation arrangements – fiduciary status
    6. 6. Delegation Requires Care, Skill, and Caution in… • Selecting an agent • Establishing the scope of the engagement • Monitoring the agent’s performance and compliance with terms of the engagement • Setting fees 7
    7. 7. Benefits of Effective Due Diligence • Make good service provider selections • Delineate roles and responsibilities • Reduce regulatory and litigation risks • Serve the best interests of beneficiaries through fiduciary excellence
    8. 8. Role and Responsibilities of Financial Intermediaries 9 Product Originator Traditional Broker Adviser counter-party agent fiduciary manufacturer salesperson professional opposite side of table intermediary same side of table buyer beware buyer be aware trust assumed (verify) “product safety” fair dealing best interest rules-based rules-based principles-based
    9. 9. Four Step Service Provider Selection Process 1. Define the services (benefits) to be delivered 2. Identify providers capable of delivering the desired services 3. Evaluate the capabilities of competing providers to deliver the services at a fair and reasonable cost 4. Engage and monitor the top-ranked provider 10
    10. 10. Best practices 1. Apply a formal Request for Proposals (RFP) process 2. Monitor service provider relationships regularly a. monitoring of investment managers is ongoing b. other service provider relationships should be evaluated approximately every three years 3. Replace service providers when you no longer have confidence in their ability to most effectively and efficiently perform the services for which they were hired 4. Typically, selection and monitoring criteria are the same 11
    11. 11. Hierarchy of investment decisions 12
    12. 12. Five Fundamental Principles of Prudent Investing 1. Prudence standard is applied at the portfolio level 2. Risk/return tradeoff is the central consideration 3. No investment is inherently imprudent 4. Diversification is required, unless it is prudent not to do so 5. Delegation to prudent experts is permitted/encouraged 13
    13. 13. Common Due Diligence Criteria • Risk-adjusted returns • Returns relative to peer group • Portfolio composition • Style consistency • Expenses • Management tenure • Product inception date and assets • Qualitative factors (e.g., support) 14
    14. 14. Complex Investments Involve Additional Due Diligence • Regulatory oversight • Firm background • Investment methodology • Risk management process • Management/personnel • Compensation/fees • Reporting capabilities • Recommendations from third party expects 15
    15. 15. Substantive and procedural prudence I know of no case in which a trustee who has happened—through prayer, astrology or just blind luck—to make (or hold) objectively prudent investments ... has been held liable for losses from those investments because of his failure to investigate and evaluate beforehand. Similarly, I know of no case in which a trustee who has made (or held) patently unsound investments has been excused from liability because his objectively imprudent action was preceded by careful investigation and evaluation. In short, there are two related but distinct duties imposed upon a trustee: to investigate and evaluate investments, and to invest prudently. - Judge Antonin Scalia Fink v. National Savings and Trust Co. 16
    16. 16. Questions? Blaine F. Aikin, AIFA®, CFA, CFP® CEO, fi360 © 2013 fi360 Inc. All Rights Reserved. 17