Prudent Practices for Investment Fiduciaries
By James J. Eccleson, Esq.
inancial advisers, trustees, plan sponsors, and anyone else involved in investment decision-making, face a host of issues as they navigate through complex and sometimes uncertain areas. But guidance is available.
One source of guidance deserves our focus. It is, "Prudent Investment Practices", a handbook for investment fiduciaries, written by the Foundation for Fiduciary Studies. A major benefit of the handbook is its simple organization. There are 5 so-called "Steps" and 27 so-called "Practices", which expand on this sound starting proposition: "To manage a prudent investment process, without which the components of an investment plan cannot be defined, implemented or evaluated." These Steps and Practices were determined after a review of the major investment fiduciary legislation - ERISA (Employee Retirement Income Security Act of 1974), UPIA (Uniform Prudent Investor Act) and MPERS (Management of Public Employee Retirement Systems Act).
Let's overview the 5 Steps and some of the 27 Practices.
Step 1: Analyze Current Position
The first Practice is to review all of the documents relating to the establishment and management of the investments. These documents include the Investment Policy Statement, minutes from investment committee meetings, trust documents, custodial and brokerage agreements, service agreements such as investment advisory contracts, regulatory filings such as Form ADV and mutual fund prospectuses, as well as performance reports. Another Practice is to ensure that the investment fiduciary knows his duties. Even if the fiduciary has delegated certain decisions to, for example, professional money managers, trustees and consultants, the fiduciary always remains responsible for matters such as: determining investment objectives, choosing an appropriate asset allocation strategy, establishing written investment policies, approving appropriate experts, monitoring activities, and avoiding conflicts of interest and prohibited transactions. Likewise, another Practice requires the fiduciary to prudently manage investment decisions and, if he or she is unwilling or unable to do so, then he or she is responsible for obtaining assistance from outside professionals who will do so.
Step 2: Diversify - Allocate Portfolio
An important Practice is to identify the risk level appropriate for the investments. In this regard, investment fiduciaries must ensure that they adequately have communicated the potential negative consequences of an investment strategy or the fact that investment objectives may not be met. Then, the fiduciary is required to state the presumptions that are being used to model the probable outcomes of a given investment strategy. Likewise, another important Practice is to identify the investment time horizon. Along those lines, the fiduciary should prepare a schedule of the investment portfolio's anticipated cash flows. At this point, one can select the asset classes consistent with the identified risk, return and time horizon. A Practice suggests that the number of asset classes and investment options will depend upon such factors as the size of the investment portfolio, sensitivity to investment expenses, as well as the decision-makers' investment expertise and ability to monitor the strategies and options considered.
Step 3: Formalize Investment Policy
One of the more critical functions of the fiduciary is to prepare and maintain the Investment Policy Statement (IPS). The IPS is the "business plan" for the portfolio. As such, it defines the duties of all of the parties involved. It provides guidance for diversification and rebalancing of investments. Another Practice suggests that the IPS define the due diligence criteria for selecting investment options. The goal is to ensure that the fiduciary not chase the latest hot Wall Street manager or the latest top performing asset class. Additionally, the IPS should define procedures for controlling and accounting for investment expenses. Another Practice requires that the IPS define the monitoring criteria for investment options and service vendors.
Step 4: Implement Investment Policy
An important Practice is to implement investment strategies in compliance with the required level of prudence. Critically, while the law does not expressly require a fiduciary to hire a professional money manager, the fiduciary will be held to the same expert standard of care, and his or her conduct will be measured against that of investment professionals. Additionally, in implementing the investment policy, the fiduciary must choose appropriate investment vehicles. One example provided relates to the decision of whether to use mutual funds or separate account managers. Another important implementation Practice is to follow a due diligence process in selecting service providers such as the custodian.
Step 5: Monitor and Supervise
The final Step is to monitor and supervise, and there are several Practices worth noting. First, the fiduciary should prepare periodic reports that compare the investment performance of the portfolio against an appropriate index, peer group and IPS objectives. A second Practice suggests examining the qualitative and/or organizational changes of investment decision-makers. There also should be control procedures in place to periodically review matters such as best execution, soft dollars and proxy voting. Finally, another Practice requires that the fiduciary determine that the fees paid to investment managers (and others) are consistent with agreements and the law.
The 5 Steps and 27 Practices are an excellent, and highly needed, roadmap for investment fiduciaries. Implement them now!
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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.
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