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Best Practices for the Selection and Monitoring of Investment Service Providers
1.
2. Best Practices for the
Selection of Investment
Service Providers
Blaine F. Aikin, AIFAÂŽ, CFA, CFPÂŽ
CEO, fi360
blaine@fi360.com
Š 2013 fi360 Inc. All Rights Reserved. 2
3. 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
3Š 2013 fi360 Inc. All Rights Reserved.
4. 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
4Š 2013 fi360 Inc. All Rights Reserved.
5. 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 âprudent expertsâ and document due
diligence
5. Control and account for investment expenses
6. Monitor the activities of âprudent expertsâ
7. Avoid conflicts of interest and prohibited
transactions
6. Establishing âReasonableâ
Service Provider Relationships
⢠A service agreement isnât reasonable if you donât
know the service providerâs
â services
â compensation arrangements
â fiduciary status
7. Delegation Requires Care,
Skill, and Caution inâŚ
⢠Selecting an agent
⢠Establishing the scope of the engagement
⢠Monitoring the agentâs performance and compliance
with terms of the engagement
⢠Setting fees
7
8. 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
9. 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)
âproduct safetyâ fair dealing best interest
rules-based rules-based principles-based
10. 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
11. 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
13. 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
14. 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
15. 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
16. Substantive and procedural
prudence
I know of no case in which a trustee who has happenedâthrough prayer,
astrology or just blind luckâto 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
17. Questions?
Blaine F. Aikin, AIFAÂŽ, CFA, CFPÂŽ
CEO, fi360
www.fi360.com
Š 2013 fi360 Inc. All Rights Reserved. 17
Hinweis der Redaktion
Now that we have covered why the new rule pertaining to 408(b)(2) was introduced and how the disclosure is to be used, letâs 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 donât 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 âteamâ 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 youâve 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 customerâs 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 brokerâs own interest can be difficult to manage.   For example, if a broker recommends buying shares in a proprietary mutual fund â one that results in a higher commission to the broker â 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 agentâs 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 clientâs 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.
