In my last two posts (Bests No. 9and No. 10), I discussed the definition of the Best Interest standard of care, with a particular focus on the duty to exercise care, skill, prudence and diligence in developing recommendations for investors.
Those articles commented on the consistency in the Best Interest and fiduciary standards being developed by the SEC and several states (including New York), as well as ERISA’s duty of care and duty of loyalty.
Bests No. 9 discussed the similarities of the standards of care and Bests No. 10 talked about the consideration of costs. This article focuses on considerations of the quality of the products and services and on portfolio investing.
Under ERISA’s fiduciary rules, advisors are required to use generally accepted investment theories and prevailing investment industry practices, based on factors such as the needs and circumstances of the investor and the purpose for the investment recommendation.
While there is not an explicit definition of “generally accepted investment theories,” the most accepted investment theory is Modern Portfolio Theory.
Generally stated, Modern Portfolio Theory contemplates a diversified portfolio of investments that are not highly correlated with each other.
Thus, while there may be cases where non-diversified recommendations could be made, the starting point—and the general rule—is that a Best Interest advisor should recommend a balanced portfolio that is appropriate for the investor.
It is fair to say that Best Interest advice mandates the use of a balanced portfolio, absent circumstances that would reasonably justify an exception.
The second subject of this article is greater emphasis on the quality of investments, products and services imposed by the Best Interest standard.
For example, an advisor (and his or her supervisory entity) would need to consider the financial stability of an insurance company when recommending an annuity.
Similarly, an advisor would need to consider the quality of the investment manager in recommending a mutual fund or collective trust.
Think about it. While many similar investments may be suitable for a particular investor, a critical distinguishing factor—in addition to cost—between different investments is the quality of the investment management.
Where an advisor is required by a Best Interest standard to (1) act with care, skill, prudence and diligence in determining which investments to recommend, and (2) to act in the best interest of the investor, it seems fairly obvious that the result of that process would be a high-quality, reasonably-priced investment.
For example, with mutual funds or collective trusts, it would mean that the investment managers had superior skills and research and that their track record supported that conclusion. In other words, it involves both a qualitative and a quantitative analysis. The qualitative analysis would look both backward and forwards.
By backward, I mean that the investment managers would have demonstrated that they are able to produce superior results.
By forward-looking, I mean that the investment advisory organization would be likely to continue to produce those results in the future. That involves consideration of the investment managers, the support staff–including analysts, the stability of the organization, the experience in managing in that style, and so on.
On the other hand, the quantitative analysis is primarily backward looking. It would be historical performance measured against appropriate benchmarks, diversification, volatility, and so on. In effect, it would be historical numbers that measure important attributes of past performance.
The considerations for annuities are similar, in the sense that the quality and strength of the organization—that is, the insurance company—are critical factors. Is the insurance company financially stable and likely to continue to be so in the future?
For example, where an annuity is recommended, the payments may extend 20 or 30 years, or more, into the future. Based on today’s financial data and the quality of the management of the insurance company, is it likely that the company will be there to make the annuity payments when due?
It is critical that advisors and their firms understand and evaluate these issues. Compliance requires nothing less.
While much of the burden of compliance falls on individual advisors, the responsibility can be shared with their firms. For example, a broker-dealer can vet the financial stability of the insurance companies that can be recommended by its advisors.
In turn, if the advisors understand that process, and reasonably conclude that it is adequate they can adopt it as their own and use it as a basis for recommending those products where they satisfy the Best Interest standard for the customer.
In other words, the responsibilities discussed in this article can be satisfied collaboratively by the combined efforts of the firm and the individual.
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The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.