From the March 2008 issue of Investment Advisor • Subscribe!

Figuring Out Fiduciary

Good intentions aren't enough to fulfill your fiduciary duties

This question has been dogging me for some time: What, exactly, does fiduciary advisor mean? Sure, advisors, as opposed to brokers, have a fiduciary duty to their clients--which means putting their clients' best interest ahead of their own--but how can an advisor know for sure if he's fulfilling his fiduciary obligations? Are there any real guidelines?

ERISA requires advisors to adhere to a set of fiduciary standards, as does the Pension Protection Act with its fiduciary advisor designation, but how can an advisor be clear about all of his fiduciary duties? To get an answer to my question (and assurance that I'm not the only one who's confused) I spoke at length with Stephen Winks, chairman of the Fiduciary Standards Council, and he assured me that there is indeed "a great deal of confusion" among advisors as to what the Investment Advisers of Act of 1940 says regarding fiduciary duties. He also says advisors confuse fiduciary standards in the '40 Act with those set out in the Uniform Prudent Investor Act (UPIA), ERISA, and The Uniform Management of Institutional Funds Act (UMIFA). "The industry has positioned advisors/brokers as salesmen of advisory products, but there is a different fiduciary duty for a money manager who can't deal with client-specific issues, versus an advisor who must deal with client-specific issues," says Winks, former head of the investment management consulting business for Prudential Securities. "What we find today is brokers and advisors are selling advice products thinking that by virtue of the sponsors of those products fulfilling their fiduciary duties that they are fulfilling theirs--that could not be further from the truth."

Some advisors mistakenly believe that good intentions are enough to fulfill their fiduciary duties, Winks says, but "there are very specific things required" when acting in a fiduciary capacity. That's why the Fiduciary Standards Council is now working on an audited prudent investment process that will provide advisors with "a safe business environment in which all advisors can acknowledge and fulfill their fiduciary obligations." Winks says the Fiduciary Standards Council is in early talks with SIFMA to use its audited prudent investment process.

"We have to find a way to reconcile commission sales (no advice) with financial planning (needs-based selling) with investment management consulting (advice as a product) with fiduciary counsel (advice as a process you manage)," Winks says.

Why is there confusion among advisors about their fiduciary obligations?

The brokerage industry, in essence, is trying to make advice a product and they have literally structured advice as a product. Under the '40 Act (both the Investment Advisers Act and the Investment Company Act), if you are a money manager you have certain obligations to the consumer but basically the '40 Act is an anti-fraud rule. But by virtue of those investment management programs being structured as '40 Act products, the sponsor is fulfilling their fiduciary obligation to the consumer, but the advisor has a whole different set of fiduciary obligations that are not covered by the sponsor fulfilling their obligation as the money manager. For example, transparency, full disclosure, pricing, all of those issues are not subject to any diligence on the part of the money manager--the money manager has a product that they sell and they are certainly at no obligation to explain what other money managers doing similar things charge for their services. But money managers do have a basic duty not to defraud investors.

The Uniform Prudent Investors Act (UPIA), ERISA, and UMIFA all entail very practical guidance for advisors and establishing what their fiduciary obligations are.

What's happening is now you have to disclose whether you are acting in a fiduciary capacity under the Merrill rule--whether you're broker or advisor or financial planner. Financial planners think of themselves as acting in a fiduciary capacity, but in truth, if you're selling an advice product, you're acting in a sales capacity, thus the confusion. Because Merrill Lynch has an advice product and they are fulfilling their fiduciary obligation, that's a different obligation than an advisor has to the client--advisors have to be transparent and act in the client's best interest whereas a money manager must stick to what they say in the prospectus or offering document.

The Rand Report confirmed that investors are confused about brokers and advisors. The Rand Report is disappointing because it didn't address any of the important questions. The [first] important question is: Is a broker selling an advice product acting in a fiduciary capacity?

The Merrill rule didn't address this question? The Merrill rule basically raised this question and the Rand Report was supposed to answer it, but the constraints within which they were engaged didn't allow them to flush out some of these important issues. The other question is: Is it not the case that the responsibilities to the investor by the advisor are totally different than the responsibilities of the sponsor of an advisory product?

The sponsor of the advisory product is acting as the money manager where they are dealing with investment-centric considerations, whereas the role of the advisor is to deal with client-centric issues.

So what's the answer to this confusion about fiduciary duties? The answer is an audited prudent investment process. An eligible investment advice arrangement, when audited, is an audited prudent investment process.

How does this work and who performs this process? It is a process within which it is a safe business environment in which all advisors can acknowledge and fulfill their fiduciary obligations. Some- thing that very few people have problems with. Essentially, the audited prudent investment process takes advice and defines it in the context of a prudent process. The prudent process is comprised of six financial services: the asset/liability study; the investment policy statement; strategic asset allocation/investment strategy; portfolio construction/manager search and selection; and performance monitoring.

There are very specific duties entailed in an advisor fulfilling his fiduciary obligations. What really is confusing is that some people feel as though good intentions are all that are needed to acknowledge fiduciary status. But there are very specific duties required to fulfill fiduciary obligations. Unless there is a highly structured process that makes it easy for advisors, it's very difficult for advisors to fulfill their fiduciary obligations because of the incredible detail required for it to be managed.

So the Fiduciary Standards Council is providing an audited prudent investment process? Wealth-Paths has been instrumental in creating the Fiduciary Standards Council. We've engaged Fred Reish, our legal counsel [and an] authority on fiduciary issues, and we have a who's who of the industry involved in this. Basically the objectives for the Fiduciary Standards Council are threefold: First is to define advice as a prudent process which will, for the first time, make advice scalable and readily manageable as a business enterprise. Second is to define the enabling resources--the processes, the technology, and division of labor--which are essential for advisors to fulfill their fiduciary obligations. The key here is we have to make it readily executable--easy for advisors to actually fulfill their fiduciary obligations. Eighty percent of the things that are required are disclosure and reporting related [items] that readily lend themselves to automation. So the incredible degree of portfolio detail required to be managed in real time could be done automatically. It doesn't require a person to spend all of their time managing process; it can be done through a division of labor and automation. The advisor, chief investment officer, and chief administrative officer [perform] the three principal functions in advisory services and what we've done is created enabling resources for the CIO and CAO functions that basically require different skill sets than advisors typically have--requires different expertise--and it allows the advisor to do things that otherwise wouldn't be possible.

The third thing the Fiduciary Standards Council is doing is creating an applications programming interface standard, which means that each element of an audited prudent investment process can talk to the others and can be upgraded and replaced without losing overall systems integration. This means the impetus for innovation when it comes to advisory services is in the public domain where vendors can compete on the basis of who's got the best investment policy statement capability, etc.

This is critical now because more lawsuits against advisors are on the way? The industry has done a good job of defending themselves on the basis that brokers are not advisors. The whole consternation here is that brokers want to be advisors. There will be a tremendous amount of lawsuits if brokers say they are advisors and can't prove it. So the remedy here is if brokers, and financial planners for that matter, want to be advisors--good intentions no longer count, you have to do the work and it has to be done in a manner that it can be audited by an objective third party to demonstrate that the advisor is fulfilling their fiduciary obligation.


Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

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