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DOL Rule Change Forces Due Diligence Process Makeover. Cut the RFP Burden by 75% with Three Key Questions.

Posted by fi360 AIFA Designee, Al Otto on October 19, 2016

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Article Credit: Al Otto®, Co-Founder & CEO Veriphy
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For retirement plan sponsors, the risks of choosing the wrong investment advisor or consultant just became a lot greater.

Spurred by new U.S. Department of Labor guidelines, fiduciaries of plans of all sizes are scrambling to evaluate qualified retirement plan investment advisors/consultants using the request for proposal (“RFP”) solicitation method. Typically, the process involves a large number of subjective questions and a small set of objective data.

However, under the new regime, which redefines the meaning of “fiduciary” as it relates to investment consultants/advisors [§3(21)] and the RFP method will likely be considered a fiduciary act. That means the mere inclusion of irrelevant questions may demonstrate a lack of knowledge and arouse suspicions regarding evaluator competency. An inability to provide objective reasons as to why a particular consultant/advisor was chosen may raise similar questions regarding credibility and the assessment process.

With that in mind, the issue becomes: how should one score a purely subjective set of questions?

Even more important, the DOL shift heightens the risk of being adversely impacted by conflict of interest issues, which are often inquired about but seldom researched or scored in other than perfunctory terms. The conflicts identified in many recent fiduciary breach lawsuits offer only a taste of the potential fallout from ignoring this issue. In my own engagements with clients, I have come across numerous RFPs that led to the selection of conflicted advisors, representing potentially serious liabilities that plan sponsors may have to deal with in future.

In fact, it is astounding how often conflicts of interest are overlooked in the RFP process, especially given the extent to which they influence the Employee Retirement Income Security Act of 1974 (“ERISA”) plan governance and oversight framework. Those who oversee the RFP process without affording sufficient weight to this important issue do so at their peril.

Certainly, the typical RFP process is overwhelming and poorly understood by many of the fiduciaries taking part. That said, perhaps the best place to start is with the identification of conflicts, specifically those prohibited by ERISA. If an investment provider or its affiliates are conflicted based on their structure or method of compensation, they can and should be eliminated from contention at the outset of the search.

Plan fiduciaries can and should ask three key questions that will go some way toward identifying conflict of interest issues, helping to significantly reduce the confusion and complexity associated with the RFP process:

1.   Will the adviser/consultant firm unequivocally serve as an ERISA fiduciary to the retirement plan and attest to that in writing?

2.   If desired by the Plan Committee, will the adviser/consultant serve as a discretionary §3(38) investment manager or named investment fiduciary to the plan?

3.   Will the adviser/consultant serve the plan without any conflicts of interest or as a level fee fiduciary, as defined by the DOL’s best interest contract exemption, and will they put it in writing?

These three questions can serve to eliminate the vast majority of fiduciary committee mistakes associated with hiring an investment consultant/advisor, and can assist plan fiduciaries in determining whether the advisor or the advisor’s firm has thought through the requirements of being an ERISA fiduciary to a qualified retirement plan.

The first question above is aimed at clarifying definitional differences between ERISA and SEC rules regarding the fiduciary duty of loyalty as it pertains to conflicts of interest. It also eliminates the need to navigate through the “seller’s exception,” as detailed in the new DOL regulation.

Under current securities laws, advisors are required to provide complete and full disclosure of conflicts of interest. A lack of disclosure, rather than a conflict per se, creates an issue for the advisor. Once the investment advisor or consultant has disclosed the conflict, it has satisfied its duty of loyalty, at least from a securities regulation perspective. According to Robert Plaze, former SEC Deputy Director of Investment Management, “disclosure and client consent will always satisfy the advisors duty of loyalty. Clients can consent to conflicts – not just some conflicts.[1]

The rules are very different for ERISA plans, however. ERISA §406(b) prohibits fiduciaries from using plan assets for their own benefit in any way and from acting in any capacity that is adverse to the interests of the plan. In other words, if a fiduciary stands to gain from a decision involving plan assets when the fiduciary plays a role in the decision, it is prohibited. Disclosing conflicts of interest does not absolve a fiduciary in any way, shape or form. In fact, engaging the services of an investment advisor/consultant with such conflicts may, in effect, be akin to posting a sign over a fiduciary’s head that says, “I’m the dummy!”

Simply put, a sponsor that is a fiduciary to a qualified retirement plan must know if it is working with an investment advisor/consultant that has conflicts of interest. Under current requirements, there is virtually no excuse for not being aware of this issue. Indeed, plan fiduciaries will likely have acknowledged this fact when they signed the investment firm’s agreement for services.

One excellent starting point for identifying the existence of conflicts of interest is the Form ADV Part 2, which is among the documents that registered investment advisors are required to make publicly available based on SEC disclosure requirements[2]. Searching through the filing for the word “conflict” will go some way toward gaining an understanding of the conflicts that a proper due diligence process is designed to reveal.

If a plan is working with a non-discretionary ERISA §3(21) investment fiduciary–that is, the advisor/consultant is receiving compensation for its investment advice and recommendations–and the advisor/consultant or its affiliates have conflicts of interest[3] – then it may be necessary to call upon an independent third party to review and approve their recommendations.

In fact, this happens quite often. However, it typically occurs without the tacit understanding of the plan's investment committee. In essence, when the latter confirms a recommendation involving a conflicted investment fiduciary, it becomes the independent third-party, which means the advisor/consultant is not engaging in a prohibited transaction. Of course, the committee and the plan sponsor are now at risk, as they tend to be selected by the plaintiffs, because they generally have the deeper pocket.

The irony of the above is that the advisor/consultant needs the plan committee’s recommendation in order to be approved, while the committee generally hires the advisor/consultant because they do not have the requisite knowledge or expertise to make appropriate investment decisions. In a legal dispute, this would likely be characterized as a “bad fact.”

Not Allowed in the Kitchen vs. Lousy Chef

This leads to question 2, which is quick way to assess the organizational structure of investment advisors/consultants–and their affiliates–and their ability to operate solely in the best interest of plan participants, as required under ERISA.

Those who have served on a plan committee in recent years are likely familiar with the two types of fiduciary designations bantered about in the sales process or in marketing materials: non-discretionary ERISA §3(21) investment advisors and discretionary ERISA §3(38) investment managers.

Broadly speaking, there are three ways that a person or entity becomes a fiduciary with respect to investment matters:

1.   They are designated as a named fiduciary or trustee in the plan document.

2.   They are indirectly delegated with discretion or responsibility over plan assets.

3.   They render investment advice to a fiduciary and are being paid a fee for that service.

A “§3(21) advisor” becomes a fiduciary because it is receiving compensation for providing investment advice to the plan, as detailed in the third item above. The §3(38) designation is different: the investment firm is a fiduciary because it has been granted discretion over investment matters for the plan or a portion of it, as detailed in item 2. It is important to understand the distinction.

A conflict of interest would prevent a firm from serving as a “§3(38) investment manager,” because this would be a prohibited transaction under ERISA §406(b). There is no exception in §408 that allows a party with discretion–but with conflicts of interest–to have their recommendations approved. They are simply not allowed in the kitchen, so to speak.

In reality, there are only two reasons why an investment firm would answer “no” to the key question about whether it would serve as a discretionary §3(38) investment manager or named investment fiduciary to the plan:

a)   The firm or one of its affiliates has conflicts of interest and they are prohibited by law from serving in the role; or

b)   The firm is not confident of its investment management abilities–that is, it doesn’t trust or won’t eat its own cooking.

Either way, plan sponsors would be wise to avoid firms that respond negatively to such a query.

Trust but Verify

The third key question, which addresses the issue of whether an advisor/consultant is willing to serve without any conflicts of interest or as a level fee fiduciary, is the final step in the due diligence process. If the answer is “yes,” then it makes sense to get it in writing from a principal or officer, along with explicit details about the compensation structure of the firm and its affiliates.

For most plan sponsors, the best strategy is to break down the RFP process into two phases. First, seek answers from the larger universe of investment advisor/consultants regarding the three key questions about conflicts of interest. Aside from mitigating the risk of having to backtrack or even restart the process later on, their responses will significantly narrow the field of candidates to research on a more in-depth basis.

Finally, once a decision is made to move forward, make sure that the prospective advisor/consultant truly understands the relevant issues and is competent. If not, the damage to the plan–and the sponsor–could prove to be more than reputational.

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