Who’s on First and What’s on Second –

James Holland
September 20, 2011 — 2,305 views  
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Who’s on First and What’s on Second –
An Important Look at Advisers and Brokers

The “Who’s on First” Abbott and Costello skit plays beautifully off of the confusion between names and the assumptive meanings poured into those names.  In ERISA, however, confusion between names and terms can have serious consequences as it relates to who services your retirement plan and what services they can actually provide. The Department of Labor (DOL) states that: “The duty to act prudently is one of a fiduciary’s central responsibilities under ERISA. It requires expertise in a variety of areas, such as investments. Lacking that expertise, a fiduciary will want to hire someone with that professional knowledge to carry out the investment and other functions.”

The perception among many Plan Sponsors, however, is that investment advisers, brokers and fiduciary consultants are essentially synonymous; hence, hiring a broker satisfies the DOL’s recommendation of hiring an expert, would it not? After all, brokers handle investment transactions, are perceived as investment experts and represent the largest investment and insurance names in the business why would this be problematic? These questions can be answered and much of the confusion can be alleviated by understanding the differences between advisers and brokers.

Standards of Conduct

The landscape is broken out into two major camps: The broker suitability model and the adviser fiduciary model. This distinction is derived from the laws and separate agencies that inform and regulate the scope of services.
Broker/Dealer Suitability Model - comes from the Financial Regulatory Authority (FINRA) rule 2310 (a)[1] that calls for “…in recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his security holdings and as to his financial situation and needs.”

The suitability standard means that the broker must know his/her client, their needs, risk tolerance, tax status, and investment objectives.  While brokers can be very knowledgeable about markets and investments, their recommendations are deemed to be merely incidental to product sales, not advice. Furthermore, the compliance departments for broker-dealer firms typically place strict limits within their contracts and agreements around their firm’s accepted liability…..and that is not to be in any fiduciary capacity. 

Unrestrained by fiduciary duty and protected by contract disclaimers, brokers are free to offer investment options that pay them incentives to place product. Outside the scope of fiduciary accountability and liability, it is not hard to imagine a broker with conflicts of interest recommending investments that pay higher incentives, thus causing a self-dealing prohibited transaction.

The FINRA Website is replete with information about and directions to investors on how to identify suitability transgressions.  Lawsuits against the Plan Sponsors of the largest corporations such as: Walmart, Caterpillar, Edison, Radio Shack have also revealed the pervasiveness of broker self-dealing.  The DOL, which in our view, does not sufficiently alert plan sponsors as to the consequences of non-fiduciary investment guidance, is nevertheless quite strong in their disciplinary language as evidenced by several post-investigation letters we have had the opportunity to review.

Hidden and excessive fees are at the crux of the issue.  Brokers hired by complacent or overly trusting Plan Sponsors can effectively dictate their own compensation through the use of preferred platforms and investments.  That, in and of itself, is a prohibited transaction both from an ERISA perspective (ERISA §406) and from a common sense business perspective.  Furthermore, receiving compensation pegged to assets ensures that it will be perpetuated and eventually excessive.

The requirement is that plan sponsors, governed by ERISA are instructed to pay only reasonable fees for services rendered. While somewhat vague, this mandate is interpretable and can be based on industry trends and benchmarks. To protect themselves and their participants, Plan Sponsor fiduciaries must require having all direct and indirect compensation reported to them, in writing and certified as to its truth, accuracy and completeness by someone who can bind the broker-dealer firm to its veracity.  The suitability standard, in and of itself does not require disclosure, bind the broker to the client, address on-going monitoring and is so broad that enforcement and recourse is difficult.  Caveat emptor, the Plan Sponsor is liable.

The Adviser Fiduciary Model

Retirement plan fiduciaries answer to federal law in the Employee Retirement Income Security Act (ERISA).  An ERISA fiduciary standard is the highest known to the law.  A fiduciary must act in the best interests of the plan its participants and beneficiaries and cannot put their personal interests before the duty.  Specifically, fiduciary standards as defined by ERISA §404(a)(1) are:
Duty of loyalty – ERISA §404(a)(1)(A): fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and—
(A) for the exclusive purpose of:
(i) providing benefits to participants and their beneficiaries; and
(ii) defraying reasonable expenses of administering the plan;
Duty of prudence – ERISA §404(a)(1)(B): with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man 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; (aka “prudent expert rule”)
Duty of Diversification - ERISA §404(a)(1)(C): by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so
Duty to Follow All Plan Documents - ERISA §404(a)(1)(D): in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of this subchapter and subchapter III of this chapter.
In response to the fiduciary question, many brokers and advisers are becoming “dually-licensed”, allowing them to operate in either capacity.  Being licensed as an adviser allows brokers to accept some limited fiduciary liability – commonly known as “co-fiduciaries”. The term co-fiduciary suggests that the Plan Sponsor and investment provider are equal partners sharing equal liability; however, co-fiduciaries are frequently careful not to accept discretionary authority, thereby continuing to leave the Plan Sponsor holding the liability bag.  Co-fiduciary in the sense it is now commonly used is not an ERISA term, is not often recognized in legal proceedings and is more used as a marketing gambit than a term that really means anything.  If anything, an adviser/broker who really means what they say, should at least accept ERISA 3(21) fiduciary duties for recommending investments to the plan sponsor fiduciary or governing committee. 

Plan Sponsors who find this option attractive should seek the far more robust and risk-relieving ERISA 3(38) Investment Fiduciary.  Brokers are unable to fulfill this role, which is why you must turn to an investment adviser.  Furthermore, it should place Plan Sponsor fiduciaries in front of fee-based advisers who are not incented to implement investments that kick out finder’s fees and revenue sharing, but only the lowest cost institutional share classes available.

Services are another differentiator. Brokers are limited, by regulation and their broker-dealers as to what functions they can perform. Brokers can provide general education on investments, but cannot give individualized advice.  Brokers may cross the fiduciary line, by giving ongoing individualized advice and receive compensation as a result of that advice, but it is done in an unacknowledged manner. Advisers, on the other hand, are limited only by their training, expertise and willingness to perform various functions.

The need for fee disclosure regulations has come about because of hidden and excessive compensation paid to brokers and other service providers.  Investment management companies are not unlike other companies that pay out for “shelf space”.  This compensation can come in many forms: finder’s fees (often 1% of plan assets, when plans move from one platform to another), 12b-1 fees, sub-transfer agent fees, trips, software, seminars etc.  None of these conform to the ERISA mandated fiduciary Duty of Loyalty and Duty of Prudence.

What is more frustrating is that often brokers tell Sponsors that by using them, their plan services are “free”.  Be very wary of that statement.  The translation is that Plan expenses will not be billed to the Plan Sponsor, but rather from kickbacks built into the expense ratios and often beyond Plan Sponsor or participant scrutiny.  In this instance “free” can be very expensive. Seek out fee-only advisers whose compensation comes from the client or plan assets only. 

Touching on New Fee Disclosure Regulations—408(b)(2)

Come April 1, 2012, the differences between advisers and brokers will be accentuated. In truth, the intent of the new fee disclosure rules has always been an ERISA mandate; however, recognizing the barriers Plan Sponsors have in obtaining compensation information from brokers, the DOL has finalized their fee disclosure regulations. This regulation forces Plan Sponsors to take on hidden and excessive fees and will arm them with the necessary recourse should service providers not comply in a timely manner. In short, the twice-delayed regulations call for disclosing:

·         All service provider income sources (who is paying?)
·         Amounts received
·         What form of payment (direct or indirect, cash or non-cash)
·         Services rendered

It is critical that Plan Sponsors do not wait for April 1. They must begin preparing immediately by insisting all service providers reveal all compensation in dollar form. Hiring a firm specializing in performing fee studies will greatly reduce the time and labor involved in this often arduous process. In the meantime, five questions can strike at the heart of the matter:

1.       Are you a broker operating under the FINRA suitability standard, or an adviser adhering to the ERISA fiduciary standard?
2.       Are you willing and trained to assume fiduciary duties (in writing)?  If yes, cite training and experience?
3.       Will you fully disclose all of your compensation arrangements certified in writing as to their truth accuracy and completeness by someone who can bind your firm?
4.       Do you receive compensation from the fund company or other entity outside of plan assets?
5.       Do you have Errors and Omissions Insurance?  What do you back your advice and actions with?

Summing up - Broker vs. Advisers – A Question of Value and Accountability

Regardless of any rules and regulations, ethical people will do the right things and unethical people will avoid doing them.  We favor an environment that is conducive to ethical behavior, having strong standards that are enforced.  That environment is the fiduciary adviser environment.  Hiring brokers to manage investments is fraught with pitfalls and increased liability. The good news is that there are an increasing number of advisers who not only assume fiduciary duties, but insist on it as a part of their service.  Look for them! 

[1] FINRA is the major broker dealer regulatory and supervisor authority.  Look at http://www.finra.org/Investors/ProtectYourself/BeforeYouInvest/AvoidCommonInvestorProblems/

James Holland


F.A.C.S. is a fee-only consulting firm that prides itself on unparalleled service and performance. We are committed to providing unbiased advice and prudent strategies for managing ERISA plans. Our services are always tailored to your unique needs. W