More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIAs failure to stay within the scope of the Section 28(e) safe harbor may violate the advisors fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients transactions.
AdvisorOne partnered with fi360 for the 2012 Article Competition. Here, the winner, Gregory Kasten, presents fiduciary best practices for actuarial implementation that can consistently improve 401(k) participant outcomes.
Great strides have been made over the past two decades to upgrade fiduciary best practices and the standard of care in the investment business. Our industry has seen the creation and widespread acceptance of groups like fi360, Committee for the Fiduciary Standard and CEFEX, and the publication of the Prudent Practices Handbook. Since passage in 1974, ERISA has always required a duty of loyalty and prudent expert standard of care. We are now seeing these duties fulfilled on a much more widespread basis. However, if our industry is to thrive, these necessary procedures must produce tangible results for the end user—the client. Tangible results are ultimately more important than simply avoiding prohibited transactions and fee transparency. For an ERISA plan, the most tangible result of all is the successful retirement of most plan participants.
The purpose of this article is not to launch into a prolonged debate about market efficiency. I hope most observers would agree that in the aggregate, the stock market cannot outperform itself. Clearly, after fees, the aggregate net investment performance of investors in the market must be below the market itself, so alpha is negative for the entire group. When investment professionals talk about alpha as their main value proposition, they have placed themselves in the untenable situation of promising an outcome that, at least across all advisors as a group, cannot exist.
This alpha value proposition view is widespread. A study by Jefferson National found almost 76% of advisors thought they added alpha. Not only does adding alpha not exist in any widespread basis, real-world alpha is actually negative in the aggregate. The fiduciary business model must have solid principles and deliver tangible results to the vast majority of clients, not just a few exceptions.
The current environment mixes market fluctuation, economic uncertainty, fee compression, DOL investigations, threat of participant lawsuits and an ever-changing regulatory landscape. The fiduciary standards under ERISA are very high. Plan sponsors have an affirmative duty to be prudent experts and to discharge all of their duties in the sole and exclusive best interest of plan participants. This creates an ideal time for plan sponsors to step back, reassess their current practices and work with an advisor dedicated to understanding ERISA and retirement planning.
Preventing something adverse from happening is mostly an intangible value. This is particularly true in small ERISA plans that have never seen a participant lawsuit, so preventing one seems hard to quantify from a value perspective. Important practices include holding regular committee meetings and calling special ones when necessary, such as significant investment news affecting the plan’s lineup. Decisions should be documented even when the decision is to do nothing. It is important to memorialize the process that you went through to reach that decision. Likewise, it is also very important to maintain a well-drafted investment policy statement. Plan sponsors need to be aware that the investment policy statement and committee minutes are regularly requested items in a DOL audit.
There is no law that requires plan sponsors to offer advice, or even education, to their plan participants. To reduce plan sponsor risk, the advisor should create a record showing everything offered to help participants achieve a secure retirement. Offering education, offering low-cost investment options and providing robust advice programs are some very important ways that you, as a plan fiduciary advisor, can help your participants along their path.
With that said, we also know that most education programs produce little impact on participants’ outcome. Inertia is simply too great. According to the most recent EBRI study, only two in 10 workers stated that they would be very likely to take advantage of such a service if it were available at a modest cost. Further, the study found that those who chose to take advantage of investment advice generally did not benefit from it because most did not implement the recommendations. Of the subset indicating they were likely to seek advice, only two in 10 said they would implement all of the recommendations they received as long as they trusted the source. Thus a minuscule 4% of all the employees (of the two in 10 receiving advice, only two in 10 will act on it) will both take advantage of the service and fully implement the advice.
Managing the Upcoming Fee Discussion
There is no doubt that for years most plan sponsors and participants have not understood what their plan costs. Understanding fees—and ensuring that they are reasonable—is something that the DOL has spent years focusing on. The market environment, combined with the litigation environment, has put fees on the forefront of plan sponsors’ minds.
Plan sponsors are now encouraged to look at not only out-of-pocket or visible recordkeeping fees, but also generally hidden investment costs and wrap fees that go along with having a fund lineup. The legal standard here is reasonableness. There is no legal requirement that plan sponsors find the lowest fee. Instead, reasonableness should be assessed in light of the services received and outcomes delivered. Plans can have different needs based on complexity, number of participants, etc. Services should be evaluated in light of the needs of that particular plan.
Periodic reviews should be documented. This is particularly true when recent events imply that an RFP needs to be conducted every three years. Many plan sponsors will now think they need to go to a “cheaper plan” to save five or 10 basis points. Cost is only the primary determinant in the absence of value. If all plans are a commodity with no value added, then plan sponsors should switch to save five basis points.
The 2012 upcoming 408(b)(2) plan sponsor fee disclosures and 404(a) participant disclosures are going to create a whole new discussion with plan sponsors. The discussion cannot be about fees only. It is also important to benchmark fees, services and outcomes. This fee discussion will make the delivery of tangible value of huge importance.
As can be seen in Figure 1 above, a benchmarked comparison can be made between total plan costs to the services of the plan (intangible value) and with measureable participant outcomes (tangible value). Plans with high cost and little value represent risk to the advisor (loss of business) and risk to the plan sponsor (participant litigation).
From Intangible to Tangible Value
In the future, the successful fiduciary advisor will deliver both intangible and tangible value in exchange for a reasonable fee. But a greater emphasis must be placed on the consistent delivery of tangible and measurable value. The tangible value proposition statement should include:
- A clear, believable and understandable statement of the tangible (quantifiable) results that will be delivered, i.e., the added value clients can expect and when they can expect it.
- A logical and evidence-based connection between the product and service being pitched and how it will favorably impact the plan sponsor and the participants.
Practices that Produce Reliable and Tangible Improvements
There are a number of tangible outcomes a plan can measure. These would include improvements in participation, savings rates, plan investment performance and appropriate participant investing based upon risk, age, funded status and generally accepted investment theory. Yet none of these is an end point of a retirement plan. The end point is successful retirement. Since successful (or unsuccessful) retirement for most participants is still far into the future, we can use an accurate actuarial projection of asset/liability funded status as a measurable proxy for retirement success. The easiest way to understand a tangible result is for the independent financial advisor to be able to say to the plan sponsor: “Before you hired us, you had 27% of employees on track for a successful retirement. After we instituted our actions, you now have 66% on track.”
It is important to include the actuarial asset liability solution as part of the tangible value solution. Generally, it can make a much greater difference in the participant’s funded ratio. In fact, the difference for a near retiree is usually 10–25 times greater than the portfolio change impact.
Figures 2 and 3 show that a 62-year-old participant’s funded ratio in a moderate risk glidepath jumps from 0.542 to 1.081, a 99.2% increase. This dwarfs the 4.4% increase from an isolated higher risk-based portfolio change for a person of this age.
The 401(k) industry almost exclusively focuses on the asset side of the equation rather than the whole equation. The industry focus is on higher investment performance, “better” managers, “better” mutual funds, “better” target-date funds, greater diversification, lower fees, etc. None of these actions has any impact on the other side of the equation—the liability—which is the cost of retirement that the participant’s 401(k) plan must bear. In order to become fully funded, the asset should equal the liability, giving an asset/liability funded ratio of 1.00 or higher. The key to success is to simultaneously raise the asset and lower the liability.
Critical Factors for Tangible Success
No system can be effective and deliver much tangible value if only used by 5% to 10% of plan participants. A single digit utilization rate is found in most voluntary advice programs. Web-based tools and calculators are used by a tiny handful of employees, but even fewer implement the advice. Without implementation, no program can succeed. Much higher acceptance rates (80%–90%) are consistently obtainable with better approaches. A default-driven pathway can ensure uniform adoption due to participant inertia. The value proposition is an individualized actuarial solution that is fully implemented by the discretionary plan trustee. Automated implementation of required actions by the trustee is the key to success. Implementation occurs whether or not the participant takes any action, other than to not opt out of the program.
Efficient data management and workflow automation can greatly increase efficiency. This is necessary to create the level of profitability to the advisor and his or her firm that makes delivery of the tangible value proposition a worthwhile endeavor over the long haul. Straight-through processing and seamless data integration, along with automated implementation of necessary actions, are required to create a pension-like experience for defined contribution 401(k) participants across many thousands of employees in plans both large and small.
As plan sponsors focus more and more on visible fees, the successful retirement advisor must deliver visible and tangible value. We can deliver a material improvement in the retirement readiness for most participants who utilize the platform. The increased tangible success rates result by combining “intelligent defaults” such as automatic enrollment, savings increases, appropriate portfolio selection and portfolio rebalancing with ongoing fiduciary and actuarial solution oversight. This approach allows the advisor to have a sustainable fiduciary business model with a clear value statement.