A Tip for Financial Advisers to Retirement Savers: Heed the Prudent Investment Rule

Today the bulk of American workers’ retirement savings, worth trillions of dollars, is in self-directed individual retirement accounts (IRAs) and defined contribution pension plans. Understandably, many workers with self-directed accounts turn to financial advisers for help in matching the vast and complicated array of investment options in today’s financial markets to the worker’s particular circumstances. However, the manner by which financial advisers are compensated has long raised concerns about conflicts of interest. Some advisers are compensated by the providers of the financial products that the adviser sells, giving the adviser a financial incentive to recommend the products that provide the adviser with the most compensation. Some advisers also engage in principal trading, a form of self-dealing in which the adviser recommends that the client buy securities from the inventory of the adviser’s firm.

To protect the integrity of financial advice to retirement savers, in April 2016 the U.S. Department of Labor promulgated a rule that imposes fiduciary status under the Employee Retirement Income Security Act (ERISA) on any person who provides “investment advice or recommendations” to an IRA owner or to a retirement plan beneficiary. This new test for fiduciary status under ERISA replaces a more complicated five-factor test under which many financial advisers to retirement savers were not ERISA fiduciaries.

The DOL’s main rationale for expanding the scope of ERISA fiduciary status was to impose the fiduciary duty of loyalty on financial advisers to retirement savers, thus ensuring that retirement savers receive financial advice that is unaffected by the personal financial interests of the adviser. Tellingly, the DOL rulemaking is entitled “conflict of interest rule” for “retirement investment advice.”

However, fiduciary status under ERISA imposes not only a trust law duty of loyalty but also a trust law duty of care. As the DOL acknowledged, a financial adviser to a retirement saver will now be subject to “trust law standards of care” in addition to “undivided loyalty.” And as regards investment management, the fiduciary duty of care under both trust law and ERISA is prescribed by the prudent investor rule.

Under the prudent investor rule, a fiduciary must evaluate the principal’s risk tolerance and investment goals and then match the principal to a well-diversified portfolio that has a commensurate level of risk and expected return. In assessing risk tolerance, there are a multiplicity of relevant considerations, including the investor’s personal risk preferences, age and health, career, family status and obligations, and other asset holdings and sources of income. Application of the prudent investor rule is specific to an investor’s particular circumstances.

Crucially, the prudent investor rule permits a wide variety of investment techniques, including active investment strategies, provided that the result is an overall portfolio with risk and return objectives reasonably suited to the investor. Under the prudent investor rule, no type or kind of investment is categorically permissible or impermissible.

In the wake of the DOL rulemaking, a financial advisory firm acts at its peril if it overlooks the prudent investor rule in updating its risk management and compliance protocols. By way of illustration, suppose that a firm were to accept management of a $200 million retirement account concentrated in a single publicly traded security. If the firm fails to diversify the account portfolio within a reasonable time, the price of the concentrated security drops by half, and a diversified portfolio would have tripled, then the firm’s liability exposure would be $500 million.

Application of the prudent investor rule to financial advisers to retirement savers creates new litigation risk for those advisers. But this risk is manageable with the compliance tools already in use by other fiduciaries, such as bank trust departments, that have long been subject to the prudent investor rule. The centerpiece of bank trust department compliance with the prudent investor rule is the “investment policy statement.” Such a statement sets forth the individualized investment program, ensuring a documented record against which to undertake periodic account reviews.

The Investment Management Handbook published by the Comptroller of the Currency summarizes thus: “The creation of an appropriate investment policy document, or statement, is the culmination of analyzing the investment assignment, identifying investment objectives, determining asset allocation guidelines, and establishing performance measurement benchmarks. The lack of an investment policy statement, or the existence of a poorly developed one, is a weakness in portfolio management risk control.”

This post comes to us from Professor Max M. Schanzenbach at Northwestern Pritzker School of Law and Professor Robert H. Sitkoff at Harvard Law School. It is based on their article, “Financial Advisers Can’t Overlook the Prudent Investor Rule,” which is available here.

Disclosure: The article discussed in this post was sponsored by Federated Investors, Inc. In accordance with Harvard Law School policy on conflicts of interest, Sitkoff discloses certain outside activities, one or more of which may relate to the subject matter of this post, here.