W. Scott Simon
People sometimes ask me to define what a fiduciary is. My short answer is that a fiduciary is someone who protects those (with whom the fiduciary has a legal relationship) that are not in a position, for whatever reason, to protect themselves. Perhaps that doesn’t comport exactly with the formal definition of a fiduciary, but that’s the way I see it.
My definition of a fiduciary inevitably leads to a discussion of why I’m a fiduciary. (A fiduciary, of course, need not personally want to protect people. It’s always possible for a fiduciary to care not a whit for those it is legally required to protect. It’s also possible that a non-fiduciary advisor can feel a moral duty toward its clients, even though it’s not bound legally by any fiduciary standard.)
Being a fiduciary–at least for me–requires a certain mindset. In my view, that is to protect people. My family lineage has spawned an inordinate amount of females who have lived long lives. So from an early age, I became unusually familiar with–not to put too fine a point on it–the lives of old ladies.
Unsurprisingly, that familiarity included up-close views of declining health and mental acuity. The fact that people can grow old, weak, and helpless with time has had, I think, a large impact on me. Many of us have experienced sorrows in our own lives. In two such situations, I have had the great privilege to be in a position as a fiduciary to protect those who grew old and helpless, and who had no one else to look after them like I could.
That kind of mindset has stood me in good stead in my career in the investment advisory profession. From the time that we first established our registered investment advisory (RIA) firm, my partners and I decided that our practice would focus exclusively on retirement plans and provide services to plan participants that would protect them from retirement plan service providers that see participants as nothing more than lambs just waiting to be led to the slaughter. That’s why we chose to become a discretionary fiduciary investment manager pursuant to section 3(38) of the Employee Retirement Income Security Act of 1974 (ERISA) for all the retirement plans for which our firm selects, monitors, and (if necessary) replaces investment options.
Assuming the fiduciary responsibilities and associated liabilities of being an ERISA-defined 3(38) investment manager produces, in my view, the biggest bang for the buck in bringing real fiduciary protection to participants (and their beneficiaries), which are, it should always be remembered, the center of the ERISA universe. (Many plan sponsors for whatever reason won’t wish to give up their inherent fiduciary responsibility to select and manage their plan investment menu but may wish, in such cases, to retain a non-discretionary fiduciary investment advisor pursuant to ERISA section 3(21)(A)(ii).)
ERISA section 3(38) reads in relevant part: “The term ‘investment manager’ means any fiduciary other than a trustee or a named fiduciary, as defined in [ERISA] § 402(a)(2) [29 USC § 1102(a)(2)]…(A) who has the power to manage, acquire, or dispose of any asset of the plan; (B) who (i) is registered as an investment adviser under the Investment Advisers Act of 1940…and (C) has acknowledged in writing that he is a fiduciary with respect to the plan.” The kind of fiduciary referenced is described in U.S. Department of Labor Advisory Opinion 2011-08A: “Section 3(21)(A) of ERISA provides that a person is a fiduciary with respect to a plan to the extent (i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets…”
Taking on the fiduciary responsibilities and liabilities of an ERISA section 3(38) investment manager, then, requires a firm to be an RIA (or a bank or insurance company). This makes a 3(38) sort of a “double-barreled” fiduciary, subject to both the “best interest” fiduciary standard of the Investment Advisers Act of 1940 (as an RIA fiduciary) as well as the (higher) “sole interest” fiduciary standard of ERISA section 404(a)(1)(A) (as a discretionary fiduciary defined in ERISA section 3(21)(A)(i)).
Controlling the investment menu that’s offered to participants is ground zero in a retirement plan. That’s why our firm provides all the retirement plans for which we take discretionary fiduciary responsibility with investment menus composed solely of low-cost, and broadly and deeply diversified investment options.
Protecting Plan Participants from Unnecessary Risk
Plan participants can be protected, in part, by being given access to menus of broadly and deeply diversified model portfolios. Broadly diversified (“horizontally” across the asset classes represented in a portfolio) and deeply diversified (“vertically” within each asset class represented) portfolios reduce risk and can help increase return. This phenomenon has to do with a mathematical rule known as “variance drain.” “Variance” is a measure of portfolio risk; reducing the variance in returns of portfolio investments–that is, lowering the magnitude of fluctuations in such returns–increases portfolio compound percentage return and therefore portfolio dollar wealth. I have written on variance drain in more detail in a previous column.
A broadly and deeply diversified portfolio that reduces risk usually goes down less in value during market downturns and requires less return during market upturns to erase the effect of such previous downturns–compared with portfolios that are less well diversified. A plan participant holding such a portfolio will “get back to even” more quickly to where it was before the reduction in value and will therefore be able to resume more quickly its continuing accumulation of wealth. Such portfolios are better diversified than “actively” managed portfolios because the latter, by definition, are always composed of some subset of the market portfolio, which makes them less well diversified and riskier. This comports with the requirement, under ERISA section 404(a)(1)(C), to reduce the “risk of large losses.”
Protecting Plan Participants from Unreasonable Costs
No doubt contributing to my fiduciary mindset is awareness of my Scottish ancestry. That has made me sensitive to costs and the need to protect plan participants from those that would seek to hoodwink them by profiting unfairly from excessive costs. Years ago, I wrote a book on index mutual funds and asked John Bogle to write the foreword to it. He didn’t know me from Adam, but after reviewing the manuscript, he graciously consented to write it. I met him later in his office at Vanguard, and we chatted about our respective Scottish ancestry. It became clear from our discussion that neither of us believed that plan participants should ever be bamboozled in any way because, among other things, neither of us would ever want to be under the power of those who could unilaterally do that to us as a participant in a retirement plan. Plan participants, of course, ordinarily do not have such power, but I know that I can legally protect them from those that do because I know where all the bodies (er, costs) are buried.
The duty of loyalty, as set forth in ERISA section 404(a)(1)(A), incorporates the duty to keep costs “reasonable”–not “low.” And yet, it seems to me that some of those who proclaim–quite correctly–that the costs expended by a plan must be reasonable in relation to the value of the services received in exchange for such expenditure are really making excuses for the high costs incurred so unnecessarily by far too many plan participants who far too often receive inadequate value in exchange.
In fact, there’s no reason why reasonable costs cannot mean low costs. To me, low costs means eliminating “visible” (explicit, stated) costs such as commissions, annual expense ratios, and 12b-1 fees, and minimizing “invisible” (implicit, unstated) costs such as revenue-sharing, trading costs, bid-ask spread costs, and market impact costs from the menus of investment options that our firm makes available to participants in retirement plans.
By the way, invisible costs are often driven up by money managers that engage in active investing– otherwise known as stock-picking, market-timing, or track record investing. These costs are invisible because they are not explicitly reflected in a disclosed annual expense ratio. Instead, they are (implicitly) subtracted from the net asset value of a mutual fund, thereby shaving its performance. Few are even aware of invisible costs, and far fewer know, in a given situation, how to approximate the amount of damage these costs can do to investment performance over short and long periods of time.
Depending on the circumstances, the invisible costs of a mutual fund can exceed visible costs. I help protect plan participants by assuring a plan’s decision-makers that both visible and invisible costs can be kept low. The idea, of course, that the visible and invisible costs generated by most active investment strategies are somehow reasonable when netted against any hoped-for outperformance is, in the first instance, intellectually silly. Unlike chess Grandmasters or Willie Mays, few active money managers exhibit consistent investment skill that’s statistically significant. It is one of the banes of our age in the investment marketplace that so many people are bamboozled into thinking otherwise. A mountain of academic studies over the last half-century backs up that assertion beyond any reasonable doubt, as does well-documented empirical evidence from financial markets the world over.
This isn’t to say, however, that there are not those who do generate investment outperformance. The insoluble problem, though, is that it’s impossible to know who these lucky (or even skillful) few will be before their track record outperformance becomes known in the future. The fact that these few comprise a larger number profiled in the investment media than would otherwise be the case if the inconvenient facts of cost-adjusted and risk-adjusted performance were taken into account is more a testament to large advertising budgets and widespread investor gullibility in needing to believe that money managers with the rare skill of the Say Hey Kid can be identified in advance.
Many non-fiduciary bundled service providers–whether they are mutual fund families, insurance companies, stockbrokerage houses, banks, etc.–know where all the costs are buried and understand how destructive they can be for plan participants. Indeed, it is these very entities that are responsible for hiding these (always high) costs so cunningly. (If costs were low, they wouldn’t be hidden but trumpeted from the rooftops.) The critical difference between these providers and yours truly is that I, as a discretionary fiduciary investment manager, can protect plan participants by outright eliminating many investment costs and minimizing others, keeping in mind to do so in a reasonable way in accordance with the great “sole interest” and “exclusive purpose” rules of ERISA section 404(a)(1)(A). Non-fiduciary advisors to retirement plans have no such constraints because they are in the business to maximally accrue investment fees for themselves. Like someone that looks through the wrong end of a telescope, they see investment costs as fees flowing to them. A discretionary fiduciary that protects plan participants sees such costs as line items that can be eliminated and minimized.
Protecting Plan Sponsors
Many service providers to retirement plans, as noted, see plan participants as lambs just waiting to be slaughtered. But many plan sponsors are also at risk of being slaughtered. Service providers generally know way more about the fiduciary duties of plan sponsors than sponsors do, and many use that superior knowledge to take advantage of them. That’s not to say, however, that sponsors cannot also benefit from the very real protection that I can provide them as an ERISA section 3(38) fiduciary investment manager. This is generally not well understood, much less acknowledged.
When plan participants are provided with an investment menu composed only of low-cost, and broadly and deeply diversified investment options, plan sponsors reduce their overall fiduciary risk. It’s rather simple: What’s good for plan participants (and their beneficiaries) is also good for plan sponsors. No plan sponsor ever got into trouble by going the extra mile to truly help out its plan participants and their beneficiaries. That’s why I can say to plan sponsors: in protecting your plan participants, I can also help protect you. Sponsors, of course, don’t have to offer retirement plans. But there’s no reason why those that do should not offer plans with investment menus that are designed in accordance with leading academic research and the law of ERISA to be both prudent and diversified.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.