The Fiduciary Duty to Keep the Fox Out of The Hen House - Part 2


In my previous post, I described the way plan sponsors often allow conflicted service providers to dictate the investment process for them, leading to a number of potential fiduciary issues.  In Part 2, I will contrast that approach with how the plan sponsor should have designed their plan and developed a sound investment policy.

First, the plan sponsor should have engaged the services of an independent advisory firm that serves in an acknowledged fiduciary capacity and preferably as an ERISA 3(38) investment manager.  The plan sponsor also should have negotiated a fixed fee with the advisory firm that was paid directly from the company or the plan (but always fully disclosed) and not through any of the funds being evaluated (thus eliminating any conflicts of interest.)  

In addition, the plan sponsor, with the aid of the advisory firm, would have separately negotiated the total billable fee with Fund Company A for recordkeeping and administrative services and required that any revenue sharing received above and beyond the billable fee be credited back to the plan which is the way this compensation structure should be utilized rather than as an additional income stream for Fund Company A.

These two steps would have restructured asset-based fees into fixed ones, and allowed the total cost from a percentage standpoint to decrease over time for participants, thereby providing pricing power and economies of scale.  In my opinion, this is an excellent fiduciary best practice and clearly better for participants.

The advisory firm then should have started by selecting the appropriate asset classes for the plan.  Asset classes at the most basic level are things like stocks, bonds, cash and alternative investments like real estate and commodities.  Within each basic asset class are sub asset classes such as large and small domestic stocks, large and small international stocks, emerging markets, US and international bonds, cash, commodities and real estate.  Beyond that are decisions about value and growth.  Each asset class has different risk and return characteristics and perform differently at different times.  Beginning the process with a focus on asset class selection would have stopped Fund Company A from dictating the process and clearly brought objectivity to the equation (rather than beginning with a conflicted focus on "required revenue").  

Next the advisory firm should have identified key metrics by which to select the specific funds for each asset class. Also, the advisory would have had a clear understanding of the significant amounts of academic research and real-life experience that show that costs and style drift are generally the best indicators of future performance.

Therefore, the advisory firm would heavily weight these two criteria which would lead to the inclusion of a high number of passively managed investments, such as index funds, increasing the probability of higher returns and substantially reducing the total investment costs for participants.  Using these key metrics, the advisory firm would then have evaluated the universe of mutual funds according to these criteria and selected preferably one fund for each asset class in the plan, thereby streamlining the number of options and reducing the confusion participants often experience when trying to make investment decisions when too many options are presented (often leading to "paralysis by analysis").

Finally, the advisory firm would determine which criteria would be used to monitor investment performance moving forward so that a judgement could be made as to whether to leave a fund in the plan or replace it if it fails to measure up within a specified time frame.  Generally, the same criteria used in the selection process would be used for monitoring purposes.  

If the advisory firm really new what they were doing, they would have then created a number of custom asset allocation models using the selected funds, thereby, creating low-cost, well-diversified portfolios for participants. Finally, the advisory firm would have taken efforts to educate participants on how to use these models correctly which is to say they should be selected as the sole investment option for both their current balance and future contributions.  

And there you have it.  An effective, low cost, highly transparent, less conflicted, easier to use plan that actually will do what it is supposed to - provide meaningful benefits to participants.  Oh, and by the way, a clearly more prudent process which leads to lower corporate and personal liability.

Could someone please tell me why this approach is so hard for plan sponsors and fiduciaries to grasp?

Click here to read Part 1.