Advisers can’t be passive when it comes to DOL rule’s fiduciary principles

All professional advisers have a common mandate — to serve clients’ best interests. This is a defining characteristic of what it means to be a professional in the classic sense of the word.
With the advent of the best-interest contract exemption, or BICE, created by the Labor Department’s conflict of interest rule, the specific meaning of a “best interest” obligation takes on heightened significance for retirement advisers.
Under BICE, advisers who receive non-level (conflicted) compensation must formally commit to serving investors’ best interests. BICE creates an enforceable contractual obligation between the client and the adviser’s firm with specific requirements designed to demonstrate that the adviser’s commitment is backed by concrete actions.
There is a dichotomy between the principles-based fiduciary standard underpinning the professional’s best-interest mandate and the rules-based requirements established under BICE.
The Department of Labor recognized that dichotomy and articulated both principles and requirements in the fiduciary rule. The principles apply to all advisers, regardless of compensation method. The requirements of BICE apply only to those who receive non-level compensation, and serve to mitigate compensation conflicts that, left unchecked, would violate overarching fiduciary principles.
The rule enumerates three key principles for the best-interest obligation: loyalty, care and individualization. These principles serve primarily to establish a conceptual framework and moral boundaries, and yet each must be applied based upon professional best practices and practical considerations.
The duty of loyalty speaks directly to the obligation to place investors’ interests first and avoid or mitigate conflicts in favor of the investors’ interests. A good working definition of a conflict of interest is a circumstance that makes fulfillment of the duty of loyalty less reliable.
Under the rule, loyalty obligates fiduciary investment advisers to act “without regard to the financial or other interests of the adviser, financial institution or any affiliate, related entity, or other party.” While many find the phrase “without regard to” difficult to understand and perhaps counterintuitive, an operative interpretation for advisers is that the amount or method of compensation must not be allowed to compromise the fiduciary duty of loyalty (i.e., to serve clients’ best interests).
Augmenting fiduciary principles with prescriptive practices, BICE requires the investment adviser to, among other things, acknowledge fiduciary status, disclose material facts (including costs and conflicts), have in place impartial conduct standards, and implement policies and procedures to uphold continuing conformity to the established standards. These requirements are designed to safeguard adherence to fiduciary principles generally, with conspicuous emphasis on the duty of loyalty.
The duty of care centers upon prudence; specifically, the well-established prudent person rule. The Employee Retirement Income Security Act of 1974 is grounded in the rich history of trust law, which informs the depth, breadth and proper interpretation of obligations attendant to investment fiduciary status.
The prudent person rule as set forth in ERISA and the DOL rule is as follows: “[T]he fiduciary [must act] with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”
For the professional adviser, the prudent person rule is often referred to as the prudent “expert” rule. This recognizes that the standard required for a fiduciary acting in a professional capacity is higher than that for non-professional or generalist plan fiduciaries.
To demonstrate fulfillment of the duty of care, advisers are expected to apply generally accepted investment theories and practices, diversify investments to mitigate risk, exercise sound due diligence to select service providers, and assure that costs and compensation are reasonable.
Finally, individualization involves formulation of personalized advice “based on the investment objectives, risk tolerance, financial circumstances, and needs of the retirement investor.” It requires the adviser to systematically gather information that is needed to determine if investment recommendations are suitable and the actions recommended are in the investor’s best interest when selecting from among available options, given the circumstances then prevailing.
From all of this, it should be apparent that there is nothing passive about fulfilling the professional adviser’s mandate to serve investors’ best interests. Each of the underlying duties — loyalty, care and individualization — require specific actions. Typically, these actions involve established professional processes and practices that are responsive to the particular facts and circumstances of the situation.
There is one additional responsibility that deserves ongoing attention by retirement advisers: documentation. For better or worse, fiduciary conduct is often evaluated in hindsight. It is not the outcome that is decisive; rather, it is a retrospective evaluation of the processes and practices that were applied in decision-making. For this reason, contemporaneous documentation is key. Fortunately, modern technology is capable of organizing, formalizing, implementing, monitoring and documenting many fiduciary activities as they occur, making fulfillment of the professional adviser’s best-interest mandate easier and more reliable.
Blaine F. Aikin is executive chairman of fi360 Inc.