About 10 years ago, one of the law firms involved with some of the first class-action lawsuits against 401(k) plan sponsors and service providers met with me to see if I would consider serving as an expert witness. I asked the legal team, why are you only focusing on fees and expenses? One of the attorneys responded: Because it is the easiest fiduciary breach to argue in front of a jury. I declined to serve as a witness.
I think the Department of Labor and the Obama administration's economic advisers have taken a similar approach. Reduce the fiduciary debate to a single sound bite that will have the most emotional impact on people: “The DOL is here to save you from bad advisers taking money out of your retirement savings.”
If that is the DOL's strategy, then shame on them.
Fiduciary responsibility is not just about fees and expenses. In fact, when you consider a procedurally prudent investment process, the management of fees and expenses accounts for less than 10% of a fiduciary's total effort. And in terms of impacting long-term investment performance, there are other fiduciary practices that have far more impact.
In 2000, I founded the Foundation for Fiduciary Studies for the purpose of defining the details and best practices of an investment fiduciary standard of care. In 2003, the foundation published the handbook Prudent Investment Practices. In all, the foundation identified 27 different fiduciary best practices which, in turn, can be summarized under five main headings. They include a duty to:
1. Identify a client's goals and objectives;
2. Allocate the portfolio to a specific risk/return profile;
3. Prepare a written statement (investment policy statement or IPS) outlining the appropriate investment strategy for the portfolio;
4. Conduct appropriate due diligence in the selection of each investment option to implement the investment strategy; and
5. Periodically monitor the investment strategy, and the individual investment options, to confirm that the strategy is still appropriate.
A subset of the duty to prudently implement and monitor the investment strategy is to control and account for fees and expenses – the only apparent focus of the DOL.
Prudence is not just about fees. In my opinion, shortfalls in the monitoring of an investment strategy have far more impact on long-term investment performance than any other factor – more so than asset allocation, manager selection, and fees and expenses. Most investment fiduciaries do a good job in selecting appropriate investment options. Where they fall short is knowing when to replace investment options that are no longer appropriate, when to rebalance, and when to revisit an asset allocation after there have been changes in the portfolio's goals, objectives, facts and circumstances. The lost opportunity cost of failing to properly monitor an investment portfolio is “costing” participants and investors far more than differences in fees and expenses.
The other issue I have with Tuesday's announcement is whether the DOL is intending to hold all advisers to the full scope of a procedurally prudent process, or only to a limited scope related to fees and expenses. Consider the following quotes from the DOL's fact sheet, emphasis added by me:
Under DOL's proposed definition, any individual receiving compensation for providing advice that is individualized or specifically directed to a particular plan sponsor (e.g., an employer with a retirement plan), plan participant or IRA owner for consideration in making a retirement investment decision is a fiduciary… Being a fiduciary simply means that the adviser must provide impartial advice in their client's best interest and cannot accept any payments creating conflicts of interest unless they qualify for an exemption intended to assure that the customer is adequately protected.
So who are the likely winners and losers if the DOL prevails with its proposed changes?
If the proposal is adopted as policy and regulation, the administration will be able to declare a victory in subjecting more advisers to a fiduciary standard of care — a promise that was made to the public following the economic meltdown.
If so, everyone else is going to lose.
Fiduciary advocates are going to lose if fiduciary is reduced to a mere examination of fees and expenses. Fiduciary will become a de-minimus standard.
Wirehouses and broker-dealers are going to lose if the intent of the DOL is to hold all advisers to the full scope of a procedurally prudent investment process. Though the DOL's announcement is only addressing fees and expenses, the term “fiduciary” carries much wider implications that will not be lost on plaintiff attorneys.
And the public is going to lose because closer scrutiny of fees and expenses is not going to have the profound impact that the administration's economists have predicted. Fees and expenses do matter, but not as much as good due diligence in the selection of investment options; an appropriate asset allocation; the preparation and maintenance of an IPS; and, a rigorous and disciplined monitoring process.
Don Trone is CEO and a co-founder of 3ethos, a firm that conducts original research and training in leadership.