Department of Labor Fiduciary Duty Rule Educational Memorandums

Transcription

1 Department of Labor Fiduciary Duty Rule Educational Memorandums 1

2 Table of Contents 1. Department of Labor Fiduciary Duty Rule Summary of Key Provisions When the Department of Labor Fiduciary Duty Rules Apply Who is a Fiduciary Fiduciary Relationship Basics Investing for Retirement Basics Duties of a Financial Fiduciary Commission-Based Accounts-Fee Based Accounts-Advisory Accounts Portfolio Construction Post Department of Labor Record Keeping

3 Department of Labor Fiduciary Duty Rule As we begin to transition our business to comply with the Department Of Labor ( DOL ) Fiduciary Law and its Fiduciary Rule, it is extremely important to understand the new Law, including how it will change our business practices and policies. If you have retirement accounts, the Law applies to you and your business will change. Over the coming weeks, I intend to provide a series of memoranda addressing the provisions of the DOL Law. Under the Law, investment advice is presumptively fiduciary in communications with IRA owners. Determining whether a communication is a DOL Advice Recommendation is the critical first step in determining whether R.M. Stark & Co., Inc. ( RMST ) and the Financial Adviser ( FA ) become fiduciaries. This will typically involve interactions with customers in various capacities, including the following: Financial Adviser Interactions Includes any Website maintained by the FA; Advertisements and Other General Communications; Communications with Prospective Investors; Communications with Current Investors; RMST s Website. Appraisals and valuations are, generally, excluded from the definition of fiduciary investment advice. The more individually tailored the communication is to the specific recipient(s), the more likely it constitutes a recommendation. A series of action, directly or indirectly (e.g., through or together with any affiliate), that may not constitute a recommendation when viewed individually, may amount to a recommendation when considered in the aggregate. DOL officials have stated publicly that they intend the determination as to whether a communication is a recommendation to follow the same guiding principles that FINRA has set forth in its guidance, including Regulatory Notices 11-25, and (available online). Under the new Law, RMST and FAs interacting with customers will be considered ERISA Fiduciary Advisers. To comply with the Law, FAs will need to fully document communications with customers and be prepared to submit all documentation to the Compliance and/or Legal Department for review. For example, if an FA communicates to an IRA account owner that a particular investment has been designed for investors like the IRA account owner, and is appropriate for this owner, in particular, the communication would likely be a recommendation (considering it is based on the individual IRA account owner s need). Whether the communication leads to a transaction or not, it must be documented and available for review. Another example 3

4 would be if the FA suggests a particular asset allocation coupled with a limited slate of investment alternatives offered by a specific product provider. It is important that you clearly understand what constitutes a recommendation. It is strongly suggested that you download and review the FINRA Notices providing guidance on the Know- Your-Customer and Suitability Obligations. Please review your business practices regarding documentation. Your documentation needs to be complete and include the date of communication, the form of communication, the basis for communication (suitability), and actions taken as a result of the communication. Documentation should be clear, concise, and in a form that can easily and regularly be provided to the Compliance and Legal Department for review. 4

5 Summary of Key Provisions-Department of Labor Fiduciary Duty Rule A fiduciary must act in the best interests of a client. A fiduciary is an individual who must act in the best interest of another person or an organization. The tradition goes back to Roman law, which recognized the duties of a "fiduciary" to deliver an inheritance to the lawful heirs. A financial adviser s fiduciary duty is the obligation to act in the best interests of another party in financial matters. Under the DOL Fiduciary Law, a financial adviser becomes a fiduciary whenever a recommendation is given to a Retirement Investor. The fiduciary is expected to have a complete knowledge of the client's financial affairs. Acting contrary to the interests of the client, or solely on the fiduciary s own behalf, is a violation of law. At any time, the Retirement Investor may ask his/her fiduciary for a complete explanation of all recommendations made on the Retirement Investor s behalf. Fiduciary duty includes making a truthful and complete disclosure of these actions. At the same time, the Retirement Investor has certain rights to supervise, and may reject, the recommendations made on his/her behalf. The Registered Representative s ( RR s ) fiduciary relationship is set by the terms of a contract. The contract states the specific duties of the fiduciary and includes the compensation for the service as well as what recourse the Retirement Investors has in case of a violation of the agreement. Determining What Constitutes Fiduciary Advice Under the DOL Fiduciary Law Fiduciary Advice is any recommendation to a Retirement Investor. A recommendation is: a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from a particular course of action as to the advisability of acquiring, holding, disposing of, or exchanging securities or other investment property; or, a recommendation as to how securities or other investment property should be invested; or, a recommendation as to the management of securities or other investment property, including recommendations regarding the selection of other persons to provide investment advice or investment management services; selection of investment account arrangements; or, recommendations with respect to rollovers, transfers or distributions from a plan or IRA. Several exceptions apply. General Marketing Communications - Furnishing information (to a plan or IRA owner) that a reasonable person would not view as an investment recommendation (i.e., general circulation newsletters, broadcast commentary, widely attended speeches, general marketing date performance reports, etc.). Providing Investment Education such as making investment-related education available to a plan, plan fiduciary, participant, beneficiary, or IRA owner, if the information does not include specific investment recommendations. Establishing an IRA Rollover Account Decisions to take a benefit distribution or engage in rollover transactions are among the most, if not the most, important financial decisions that plan participants and beneficiaries, and IRA owners can make. Advice provided at this juncture, even if not accompanied by a specific recommendation as to how to invest assets, should be treated as investment advice. Even if the assets will not be covered by ERISA or the Code when they are moved outside the plan or IRA, 5

6 the recommendation to change the plan or IRA investments is investment advice. Recommendations to take a distribution or rollover to an IRA, and recommendations not to take a distribution or to keep assets in a plan, should be treated the same in terms of evaluating whether the communication constitutes fiduciary investment advice. Consequences of Failing to Meet the Conditions of an Exemption Noncompliance will result in different claims and remedies depending on whether the advice concerns an ERISA plan, a non-erisa plan or an IRA. If the advice concerns an ERISA plan, federal courts would have exclusive jurisdiction over any claim for violation of the Law resulting from a non-exempt prohibited transaction. If the advice concerns an IRA or a non-erisa plan, any breach of contract claims could be brought in state court. Whether the advice concerns an ERISA plan, a non-erisa plan, or an IRA, any imprudent violation could expose the financial institution and RR to an excise tax under Section 4975 of the Code. The Meaning of Best Interest Advice Advice is in the Best Interest of the Retirement Investor if it meets a prudent standard without regard to the financial or other interest of the Adviser. The prudent standard of care can be divided into two categories: macro and micro. The macro requirement is that the investment products be prudent for Retirement Investors generally. The micro requirement is that the recommended combination of investment products and services be prudent for the particular investor to whom the recommendation is made. For example, with insurance products such as variable annuities, one macro issue is whether the insurance company is financially stable that is, based on current circumstances, will it be able to make annuity payments 30, 40 or more years from now? The second level of analysis the micro level- involves the individualization of the products and services to a particular investor. Having said that though, it is important to keep in mind that, regardless of whether we are talking about a 35-year-old investor or a 65-year-old investor, the purpose of an IRA is to provide retirement benefits. It should not be viewed simply as a pool of investment money. The Scope of the Best Interest Contract Exemption ( BICE ) An executed contract is required for IRA accounts and is a two-party contract between the Retirement Investors and the Financial Institution ( FI ). The FI is required to acknowledge that both it and the RR are fiduciaries. Level-Fee Fiduciaries are exempt from most of the conditions of the Exemption. Permitted assets are effectively ranked within two tiers. Tier 1 is generally permitted investments. Tier 2 is everything else and generally requires special care, training, and ongoing monitoring arrangements. In effect, the BICE is a compendium of related exemptions for Advice regarding: ERISA plans; IRA and IRA rollovers; propriety products, or nonproprietary products providing Third-Party Payments; the transition period from April 10, 2017, to December 31, 2017; and, in connection with arrangements existing on April 10,

7 Reasonable Compensation Under the BICE The FI must insure that no more than reasonable compensation is paid to the firm and RR. The reasonableness of compensation depends on the particular facts and circumstances at the time of the recommendation. Market pricing of services provided and the underlying assets, the scope of monitoring, and the complexity of the products are all factors. No single factor is dispositive in determining what is reasonable. The focus of the reasonable compensation condition is to prevent overcharges. A firm does not have to recommend the transaction that is the lowest cost, or that generates the lowest fees, without regard to other factors. Material Conflicts of Interest Material Conflicts must be identified and documented. Measures must be adopted to prevent Material Conflicts from causing violations of the Impartial Conduct Standards. Conflicts of interest include: sales quotas; appraisals; performance or personnel actions, bonuses, contests, special awards, differential compensation, or other actions or incentives that are intended, or would reasonably be expected to cause RRs to make recommendations not in the Best Interest of the Retirement Investor. Differential compensation that is not counter to the Retirement Investor s Best Interest is allowable. Disclosures Required Under the BICE The BICE requires a full set of disclosure requirements including, but not limited to, contract, pretransaction, web, and upon-request disclosures. Disclosures must include: The Best Interest Standard; a description of the how the Retirement Investor will pay for services; material conflicts; right to obtain copies of the firm s anti-conflict policies and procedures; as well as, specific disclosure of costs, fees and compensation. The FI must also include a discussion of the business model, a model contract, a list of all parties from whom the FI receives third-party compensation, and a description of compensation arrangements with advisers. In addition, the Retirement Investor may also request a history of communications and recommendations related to the retirement account. The Information to be Collected and Retained from Retirement Investors Under the DOL Law there are certain recordkeeping and access rules. Retirement Investor records must be retained for six years and, subject to certain limitation, the RR must provide unconditional access during normal business hours to designated persons, including: (a) DOL or IRS representative; and, (b) participants or IRA owners (or their representatives). The RR must ascertain the Retirement Investor s risk tolerance, investment objectives, and financial circumstances. In addition, the RR must maintain a written record of verbal and written communications with the Retirement Investor. The record must include the date, content of the communication, any recommendations, and any action(s) taken as a result of the communication. Bear in mind that any recommendation, whether or not it involves a securities transaction, is of equal weight and must be recorded. RRs will be asked by the Compliance Department to submit required records on a periodic basis. 7

8 Grandfathering The BICE includes a grandfather provision for retirement accounts in existence on the Applicability Date (April 10, 2017). RRs can only provide limited advice related to grandfathered accounts. For example, a mutual fund or variable annuity exchange may be permissible provided that the program was set up prior to the Applicability Date. Grandfathering does not cover any advice relating to new investments for, or any additional investment in, a grandfathered account. Compensation from a grandfathered account can be paid to the RR provided the compensation is not in excess of reasonable. 8

9 When the New DOL Fiduciary Duty Rules Apply Following is a list of applicability dates to be in compliance with the DOL Fiduciary Law: 1) April 10, 2016, Final Rule Issued; 2) June 7, 2016, Effective Date, Final Rule officially became Law, no longer subject to amendment; 3) April 10, 2017, Applicability Date, Final Rule fully applicable; 4) January 1, 2018, Prohibited Transaction Exemption ( PTE ) relief subject to all conditions; 5) Transition on-boarding disclosure: Until April 10, 2017; 6) April 10, 2017 a. Best Interest Advice, b. Reasonable Compensation, c. No Misleading Statements, d. Recordkeeping and access e. Investment Education exemption in effect, f. Generalized Information and Communication exemption in effect. 7) Prior to January 1, 2018, existing contracts may be amended by negative consent, subject to certain conditions. 8) New Contracts (an enforceable written contract that includes all of the terms specified below) must be entered into prior to, or at the same time as the execution of a recommended transaction. 9) January 1, 2018 a. FI must enter into a written contract with the retirement investor including but not limited to the following contract terms, i. FI and RR are fiduciaries under ERISA, ii. Adherence with the Impartial Conduct Standards, iii. Advice must be given in the Best Interest of the Retirement Investor, iv. Statements about recommended transactions, fees and compensation, Material Conflicts of Interest, and any other matters will not be misleading, v. FI must warrant that it has developed and will comply with policies and procedures designed to ensure RRs will adhere to the Impartial Conduct Standards. 9

10 vi. FI must formulate policies and procedures that identify and document any Material Conflicts of Interest and has adopted measures to prevent conflicts from causing violations of the Impartial Conduct Standards, vii. May not contain exculpatory provisions disclaiming or limiting liability, viii. May not wave the Retirement Investor s right to bring or participate in a class action against the RR or FI, ix. May not provide for arbitration in a distant venue or unreasonably limit the ability of the Retirement Investor to pursue claims. b. Onboarding/transaction/web disclosures, c. FI Policies and Procedures complete d. Notification to DOL. 10

11 Who is a Fiduciary? The Education Exemption Clearly, every Financial Adviser engaged in the business of servicing retirement accounts is considered a fiduciary. Consider the definition: A person is a fiduciary if, for a fee, that person provides to a plan, plan fiduciary, plan participant or beneficiary, IRA or IRA owner: 1. A recommendation a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from a particular course of action as to the advisability of acquiring, holding, disposing of, or exchanging securities or other investment property; or, 2. A recommendation as to how securities or other investment property should be invested; or, 3. A recommendation as to the management of securities or other investment property, including recommendations regarding the selection of other persons to provide investment advice or investment management services, selection of investment account arrangements, or recommendations with respect to rollovers, transfers or distributions from a plan or IRA; and, Such person, directly or indirectly (e.g., through or together with any Affiliate): 1. Represents or acknowledges that it is acting as a fiduciary; 2. Renders the advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is based on the particular needs of the advice recipient; 3. Directs the advice to a specific recipient regarding the advisability of a particular investment or management decision with respect to a plan or IRA securities or other investment property. You may recall from the previous memo that a Recommendation means a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engages in or refrain from taking a particular course of action. There are certain exceptions to what are considered Recommendations: 1. General marketing communications: furnishing information (to an IRA owner) that a reasonable person would not view as an investment recommendation; 2. Providing Investment Education: Making investment-related education available to a plan fiduciary, beneficiary, or IRA Owner so long as the information does not include specific investment recommendations. When providing plan information, the Education Exception does not permit any reference to appropriateness of individual benefit distribution options for an IRA but may include descriptions of varying forms of distributions and other forms of lifetime payment options (e.g., immediate annuity, deferred annuity, or incremental purchase of deferred annuity), advantages, disadvantages and risks of different forms of distribution. General investment information still may not include information on specific investment products, plan alternatives, or distribution options, or specific alternative or services outside of the plan. It 11

12 may, however, provide information about retirement-related risks (longevity, market/interest rates, inflation, etc.) and general methods and strategies for managing assets in retirement, including outside the plan. With respect to asset allocation models, the preamble suggests an ongoing duty to monitor plan service providers and to evaluate whether the information is unbiased. Asset allocation models that describe a hypothetical portfolio could fit into this category. According to Commentary provided by the DOL, with IRAs, presentation of specific investments generally, rises to the level of a recommendation because there is not an independent fiduciary reviewing and selecting the investment alternatives. Interactive investment materials may, however, identify specific investment alternatives if they are specified by the IRA owner. As asset allocation model for an IRA could still qualify as Education under the final rule if it described a hypothetical customer s portfolio as having certain percentages of investments in equity securities, fixed-income securities, and cash equivalents, or if it described a hypothetical portfolio based on broad-based market sectors (e.g. agriculture, finance, manufacturing, mining, retail, services, transportation and public utilities, and wholesale trade). The asset allocation model would have to meet other criteria in the DOL final rule and could not include specific investments. The use of asset allocation models and interactive materials with specific investment alternatives available through a self-directed brokerage account is not covered by the Education Exception in the final rule. In other words, once a Financial Adviser provides any information beyond that permitted under the Education Exemption, he/she becomes a fiduciary and must represent or acknowledge that he/she is now acting as a fiduciary. Any recommendations must be given subject to an agreement that the advice is based on the particular needs of the advice recipient. The practical implication related to generalized information and communications is that discussing specific investment products, plan alternatives, distribution option and specific alternatives or services outside the plan is considered fiduciary investment advice. Information not considered fiduciary advice includes retirement-related risks (longevity, market/interest rates, inflation, health care, etc.); neither is general methods and strategies for managing assets in retirement, including outside the plan. Finally, investment advice does not include general communications that a reasonable person would not view as an investment recommendation including: 1. General circulation newsletters; 2. Television, radio, and public media talk show commentary; 3. Remarks in widely attended speeches and conferences; 4. Research reports prepared for general distribution; 5. General marketing materials; 6. General market data, including data on market performance, market indices, or trading volumes; 12

13 7. Price quotes; 8. Performance reports; or, 9. Prospectuses. Clearly, prior to providing any advice, the Financial Adviser must have a basis for the recommendation. The guidelines for determining Suitability and Knowing-Your-Customer apply, as do the requirements for documenting your communications. 13

14 Fiduciary Relationship Basics There are various types of fiduciary relationships. There are those created under the law as applied to particular relationships governed by statute (such as the DOL Fiduciary Law), or by legal proceedings (such as administrator and heir). While there is no definitive description of a fiduciary relationship, one source describes it as: The acting of one person for another; the having and the exercising of influence over one person by another; the reposing of confidence by one person in another; the dominance of one person by another; the inequality of the parties; and the dependence of one person upon another. Whenever one party places trust and confidence in a second person with that second person s knowledge, it is possible that a fiduciary relationship is created. Such a relationship imposes on the fiduciary the duty to act in the best interest of the person who has placed his or her trust and confidence in the fiduciary. As a result, the fiduciary may not simply deal with that party at arm s length, guided only by the morals of the marketplace. Numerous fiduciary duties arise under the DOL Law. The most common of these are: 1. Duty of care; 2. Duty of loyalty; 3. Duty to account; 4. Duty of confidentiality; 5. Duty of full disclosure; 6. Duty to act fairly; and, 7. Duty of good faith and fair dealing. Historically, the most common basis for imposing fiduciary duties on Financial Advisers ( FAs ) is the common law agency status we occupy in relation to our customers. In the federal context, FAs may be held to fiduciary standards contained in the Investment Advisers Act of Courts have examined both stockbroker and investment adviser conduct in determining whether to impose fiduciary liability under various statutory and administrative regulations, such as section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b However, there must be some relationship in order to establish liability. In addition, rules of the various stock exchanges have been used by courts to impose fiduciary liability on FAs for failure to live up to industry standards. The extensive regulation scheme under the DOL Fiduciary Law creates a fiduciary relationship, which undoubtedly will have some impact on civil suits for breaches of fiduciary duty. Fiduciary duties under the Employee Retirement Income Security Act of 1974, 29 U.S.C. section 1001, et seq. ( ERISA ) have already existed prior to the new law. A frequently litigated area of business tort litigation involves disputes arising under ERISA which was enacted by Congress to provide, inter alia, a comprehensive scheme of federal regulation of employee benefit plans, including retirement and medical plans. Generally speaking, a person has been a fiduciary under ERISA to the extent he or she exercises discretionary authority over the assets of an ERISA plan (such as a pension or profit-sharing plan), renders investment advice for a fee with respect to the assets of the plan, or has any discretionary authority in the administration of the plan. The ERISA 14

15 statute clearly delineates that plan fiduciaries shall discharge their duties with respect to a plan solely in the interest of the participants and beneficiaries. There are literally hundreds of ways in which fiduciaries may breach the duties correlative to their special status. Among the most common breaches related to our business are the following: 1. Self-dealing (i.e., through conflict of interest or reaping of extra profits); 2. Misappropriation of funds or property; 3. Neglect, imprudence, or want of skill (e.g., failure to properly diversify retirement plan investments); 4. Failure to act in another s best interest; 5. Misrepresentation/omission as to a statement of fact (e.g., financial condition/statement of affairs); 6. Inducement; 7. A breach of an assumed duty (e.g., to provide accurate information); 8. Misuse of confidential information/breach of confidentiality; 9. Misuse of superior knowledge; 10. Failure to disclose; and, 11. Rendering inappropriate advice (e.g., bad investment advice). Actions against FAs prior to the DOL Fiduciary Law have not been uncommon. Some courts have imposed fiduciary liability on stockbrokers based on the agency relationship between a stockbroker and the customer. Others have used the rules of the various stock exchanges as industry standards in determining whether a broker has breached a fiduciary duty with regard to the handling of an investor s account. Regardless of the source, it is clear that we, as FAs, are required under the fiduciary duty to act in the best interest of the customer. Prior to the DOL Fiduciary Law, the question was one of scope. In Robinson v. Merrill Lynch, Pierce, Fenner & Smith, Inc., the district court held that where a broker was executing orders to buy and sell for a customer, the only duty owed to the customer was to properly execute the order. The U.S. Court of Appeals for the Tenth Circuit went one step further in the case of Hill v. Bache, Halsey, Stuart, Shields, Inc. There, it held that, even when a broker does undertake to give a customer trading advice, the broker cannot be legally responsible if the opinion turns out to be incorrect. The California Court of Appeals in Duffy v. Cavalier opined that the scope of a stockbroker s fiduciary duty to a customer depends on the specific facts and circumstances presented in a given case. These include the relative sophistication and experience of the customer; the customer s ability to evaluate the broker s recommendations and exercise an independent judgment thereon; the nature of the account, whether discretionary or nondiscretionary; and the actual financial situation and needs of the customer. However, the past findings related to FAs being fiduciaries no longer apply to retirement accounts. The relationship of a FA to the advice receiver is that of a fiduciary if the FA provides any communication that is deemed to be a recommendation. FAs now have all of the duties of a fiduciary and can be held to account for any breaches. Finally, under the new law, customers will no longer be bound by Arbitration Agreements. When we introduce our new Best Interest Contract ( BIC ), it will include an Arbitration Clause as well 15

16 as language that the customer is not bound to arbitration and can bring an action alleging damages in state court. This will result in increasing the cost of the litigation and opening the door to additional complaints such as class action suits. Source, in Part: Breach of Fiduciary Duties, Chapter 1, American Bar Association, Robert A. Kutcher, Wagar Richard Kutcher Tygier & Luminais, LLP, Metairie, LA. 16

17 Investing for Retirement Basics To ensure a comfortable lifestyle during retirement, it is necessary to establish and maintain a savings plan that will bridge the gap between the income needed to retire comfortably and the income Social Security provides. Most people are not saving enough for retirement. In fact, until recently, the overall savings rate has been falling for more than 20 years. Currently, the personal savings rate as of Q is at 5.4%. The rate peaked in 2012 at 8.6% and troughed during 2005 at 2.2%. Those individuals that are saving for retirement are best served by participating in tax-favored retirement plans such as 401(k)s and Individual Retirement Accounts ( IRAs ). 401(k) plans have been regulated by ERISA for some time. Investor choices are often limited to a select group of mutual funds and there are, generally, restrictions on distributions and trading activity. As a rule, participants in 401(k) plans generally grow their investment assets over time, ultimately turning the asset into an income producing vehicle during retirement. The focused investment approached does not protect the assets against market risk, (only asset allocation can protect against market risk), but due to the diversification offered by mutual funds, the risk of a significant or devastating loss is minimized. The IRA has been a less predictable savings account. Until recently, there were few regulations on IRA investments. With the exception of the most aggressive investment strategies, most strategies and products were permitted. Often, IRA investment strategies have been deficient, thus resulting in a disappointing performance. The new Department of Labor ( DOL ) Fiduciary Law has brought retirement accounts under close scrutiny. While the Law does little if anything to focus on important issues, such as asset allocation, diversification, and discipline (the Law focuses primarily on costs), it does make financial institutions fiduciaries thereby hoping this legal change brings improved performance to IRA investors in general. What the DOL fails to realize is that an improperly invested account that pays zero fees can still result in devastating performance. As professionals, we deserve to get paid for the experience we offer and services we provide. We also have the obligation to provide a well thought out investment plan that is suitable for retirement investors based upon his/her investment horizon, financial resources, and risk tolerance. With the new Law, we now have an opportunity, and an obligation, to bring to the table time-tested principals that, when followed, will improve the average performance (or, at the very least, reduce the possibility of a devastating loss) of a retirement account. Change will not come easy. There will be resistance. The first level of resistance may come from financial professionals. Why should we change what we have been doing for years? If we take an honest look at ourselves, we can do a better job. Second, there will be some resistance from investors themselves. This is inevitable. Individual investors often lack any experience or training to manage their investment accounts. Almost without exception, accounts solely managed by the investor are deficient and thus exposed to higher than necessary risks. 17

18 As fiduciaries, we now have the obligation to set the standard. Not everyone will agree with the standard and we will not do business with everyone. But, at least we will know that what we are doing is sound, is appropriate for the purpose of saving for retirement, and will protect the individual financial adviser and the firm from litigation. Change often requires new thinking. In this case, we must change our thinking from brokers selling products, to fiduciaries charged with the responsibility of advising our clients in all matters related to a retirement account. We will no longer receive compensation from commissions but, rather, from fees earned as a fiduciary. We must also accept the fact that compensation is changing. Early indications suggest that in the aggregate, the change may be minimal. Some clients may pay more; some may pay less. However, as we move to flat-fee pricing, clients will know what they will pay and financial advisers will know what they will earn. Differential compensation will be replaced by flat-fee compensation. Compensation sources, such as 12b-1 fees and service charges, are headed for oblivion. Firms have to change to properly execute the duties of a fiduciary. Financial representatives have to accept greater oversight and will be held to a higher standard. No longer will a financial adviser be able to choose from an unlimited universe of investment choices. There will be change in product platforms. Product platforms will be selected by the firm (with the input of associated professionals) and will be universal throughout the organization. The products themselves are important and must be structurally sound. Retirement investors will be well-served in managed products. Managed accounts can offer investors strategies and disciplines often not seen at the retail level. Financial advisers will have to realize that a Series 7 registration alone will not qualify them to offer many of the products available in the retirement market. A RIA registration is a must for advisers who wish to serve the retirement investor. Clients, too, will have to change - but this is probably the easiest task we will have to tackle. With proper education, clients will come to appreciate that they are the ultimate winners. They will come to realize that our services are driven by one major objective: to maximize our clients retirement savings to ensure they experience the best retirement years possible. Let s get specific. What are our duties as fiduciaries of a retirement plan? In the simplest of terms, we must act solely in the interest of retirement investors and their beneficiaries, carry out our duties in a prudent manner, diversify retirement account investments, and charge a reasonable fee. Among brokers, there are varieties of opinions regarding what is in the best interest of investors. This firm s view is that as a fiduciary of a retirement account, the number one priority is to manage risk. When risk is not managed, the probability of loss is increased. In a retirement account with limited financial resources, it may not be possible to recover a loss that could have been avoided by better risk management. 18

19 As fiduciaries, we have the obligation to gather information and use all the tools available to manage risk and strive for positive returns. We must have a complete understanding of each client s circumstances, his/her tolerance for risk, and his/her investment horizon. We are obligated to stress the importance of proper asset allocation, securities diversification, and ongoing monitoring and rebalancing. We must recognize, and discuss with clients, the dangers of market timing and embrace a longterm market strategy. History shows that there is a significant cost to attempting to time the market. During times of downturns, we stick to our disciplines and attempt to keep our clients on track. The securities suitable for each investor will, in large part, be determined by the size of the account. Regardless of the account size, all of the elements discussed above must be met. For most investors, the most suitable investment products will be mutual funds and exchange traded funds. Each of these offers important diversification and reasonable fees. There are, however, certain funds that would not be suitable. Any fund that employs leverage as part of its strategy is, generally, unsuitable; leverage has the potential to expose a retirement account to unrecoverable losses. Other strategies that may be bizarre or, at minimum, difficult to understand, are also not candidates for retirement accounts. For new investors beginning to save for retirement, it may not be possible to meet basic portfolio requirements by investing in individual securities. To achieve the proper asset allocation and diversification, an actively managed asset allocation, or target date fund, may be the most suitable. Periodically adding funds (dollar cost averaging) and dividend reinvestment should, over time, meet the objective of saving for retirement. Mid-sized accounts, (the majority of retirement accounts), that are not large enough to purchase individual securities and achieve the targeted asset allocation and diversification are best suited for mutual funds and exchange traded funds. A target date fund is still suitable but, for those investors hoping to enhance performance, a portfolio of carefully researched and selected funds is a suitable strategy. Target date funds incorporate periodic rebalancing as the investor ages. When investing in other than target date funds, periodic rebalancing is necessary to ensure proper risk management. Larger accounts have more choices. Funds and individual securities can be suitable. The question is, as a fiduciary, how large does an account need to be to invest in individual stocks and bonds? We can only approach this question by building a portfolio. Let s take a hypothetical 45-year old with a Moderate Risk profile. An appropriate asset allocation would be 42% domestic equities, 26% non-us stocks, 13% bonds, 3% real estate and 16% hard assets. Studies show that to achieve sufficient diversification within a sector, a portfolio should include, at a minimum, sixteen positions, with each position not to exceed 2% of the total assets. It is generally not practical to buy individual non-us stocks. A mutual fund can be used to meet the proper sector allocation and will provide the necessary diversification. Similarly, purchasing 19

20 individual hard assets is not practical and, therefore, a fund is, again, the best option. When purchasing fixed income securities, we have two primary risks: credit risk and interest rate risk. Mutual funds are an option, as are individual bonds. Individual bonds are generally offered in five bond ($5,000) minimums. Assuming a minimum purchase of $5,000 not exceeding 2% of total portfolio assets, a portfolio with a minimum of $250,000 equity is required. Lastly, we need to incorporate a minimum of sixteen domestic stocks each with a maximum value of 2%. We know the portfolio needs a minimum of $250,000 in equity to properly diversify the fixed income assets. We also know that 42% of the portfolio should be invested in domestic equities. Assuming we invest in the minimum number of issues (16) required for proper diversification, each position size will be $6,562. While this portfolio would be suitable, the costs of constructing it and maintaining it need to be considered as a fiduciary. Many more decisions need to be made to manage this portfolio properly. Each decision made as a fiduciary can have consequences. It doesn t matter if the decision is to buy, sell or hold. Reasonable fees that would need to be charged to service this portfolio would be higher than those of a straight mutual fund portfolio. As fiduciaries, should our conclusion be that the likelihood of improved performance warrants the extra expense and increased risk? As fiduciaries, a reasonable conclusion would be that accounts with less than $250,000 in assets are better suited by investing in mutual and exchange-traded funds. Because of the time and work involved to properly manage a larger portfolio, a good choice may be to retain an outside manager. Assuming a portfolio managed by either an individual financial adviser or an outside manager achieve the same performance, there are still other benefits to outside management. These include: 1) If the account s performance fails to meet expectations, you have a better chance of retaining the account if it is managed by a third-party (you can always replace the manager and keep the same broker); 2) Outside management allows the financial adviser to better utilize his/her time. Rather than being engaged in every trading decision, focus on raising new assets if your goal is to increase your income. In summary, the DOL Law is forcing us to refocus on how we service retirement accounts. Ultimately, both the client and adviser will benefit. Change is here, embrace it, and use it to your advantage. As a firm, we are working diligently to structure our retirement account offerings in a manner that we believe will be most beneficial to retirement savers and convenient and profitable for advisers. We recently introduced the Stark Financial Advisers Wealth Allocation Program and the R.M. Stark Wealth Allocation Program Flex Account. We are also in the process of rolling out the Managed360 platform. Any of these programs can provide services on a par with any competitor and at a reasonable cost. We all know that change is inevitable. The best kind of change comes when you envision, initiate and control it. That type of change creates opportunities, transforms companies and ignites growth. Otherwise, you are faced with the damaging prospect of change that happens in spite of you - rather than because of you. 20

21 Duties of a Financial Fiduciary Investors planning for retirement have essentially two goals: (i) providing and maximizing retirement income; and, (ii) leaving an inheritance for their customers beneficiaries. The process of planning for retirement has two stages: (i) the accumulation stage; and, (ii) the distribution stage. During the accumulation stage, the retirement investor s goals should be to: (i) maximize retirement savings plans; and, (ii) grow the retirement asset without incurring unnecessary risks. Focusing on these objectives will help assure the maximum income at retirement and, hopefully, result in an inheritance residual. As a fiduciary we must act in the best interests of our clients by putting their interests ahead of our own. This means that we must avoid conflicts of interest and operate with full transparency. A fiduciary is prohibited from making recommendations that produce higher commissions for themselves in the role of financial adviser or their investment firm. Recommending proprietary products does not violate a fiduciary s duty provided the proprietary products are not more expensive or expected to provide lower returns when compared with similar non-proprietary investments. We must also espouse a disciplined and repeatable investment approach. Importantly, we must obtain and continuously monitor not only our clients investments but also their changing financial situations. The solutions we offer incorporate tried-and-true principles: risk-appropriate portfolio construction; broad asset allocation; and, sector diversification. Often, to gain acceptance for these solutions, we need to provide education. We cannot assume that our clients understand the many risks that could affect their retirement savings. Most do not understand the importance of having broad asset allocation and sector diversification. Many confuse asset allocation with diversification. Few understand how adjusting a portfolio s asset allocation, coupled with proper diversification and periodic rebalancing, can impact portfolio returns and risk. We have a duty to promote these understandings. A major difference between the suitability and fiduciary standards is there is little obligation to monitor a client s investment after the purchase under the suitability standard. A fiduciary has a duty of care and must continually monitor not only a client s investments but also changes in his or her financial situation. For fiduciaries, the first client meeting marks only the beginning of the adviser s legal obligations. The solutions we offer meet all the requirements that R.M. Stark & Co., Inc., as a fiduciary, has an obligation to provide: 1. Obtaining and maintaining accurate customer profiles; 2. Offering numerous portfolio solutions, models, and variations thereto which span the risk/return spectrum; 3. Providing ongoing portfolio monitoring and rebalancing; 4. Flat-fee, competitive, transparent pricing. 21

22 We are excited about the prospects ahead of us as we enter the Post-DOL world. We have thoughtfully considered our obligations and expectations and, by helping our investors achieve their goals, we also will achieve ours. 22

23 Commission Based Accounts Fee Based Accounts Advisory Accounts In recent years, the SEC and FINRA have both focused upon firms policies and procedures related to the suitability of commission brokerage vs. fee-based accounts. Registered Representatives ( RRs ) must make a determination of which to recommend in connection with an IRA. In making the determination the RR should consider: 1. The size of the account; 2. Whether a fiduciary relationship exists; and, 3. Whether the investor desires the structured portfolio management restrictions characteristic of a fee-based account. To offer a fee-based account you must have grounds to believe that, based upon the services provided, cost, and customer preferences, fee-based pricing is appropriate. NASD Notice to Members (published prior to the DOL Fiduciary Law) sets forth helpful factors to consider. It does not take into account, however, the change in the legal relationship between a financial institution, RR, and customer. When considering which to offer, keep in mind that the RRs who only hold a Series 6 or 7 can only offer their customers non-advisory accounts. To offer an advisory account, you must be registered as an Investment Adviser with Stark Financial Advisers, Inc. ( SFA ). DOL commentary cautions that the recommendation of an advisory vs. a brokerage account must be appropriate. The DOL also cautions that, in some instances, putting an investor in an advisory account, as opposed to a brokerage account (or vice-versa), could violate the fiduciary standard if the wrong account is recommended. For example, an investor with whom the RR does not have a fiduciary relationship (is not providing recommendations), is not likely to be suitable for a fee-based account. Clients with whom the RR has a fiduciary relationship are potential candidates for fee-based pricing. Under the DOL Law, RRs providing recommendations (suggestions that the advice recipient engages in or refrain from a particular course of action) are fiduciaries and by default have the duties of loyalty, care, and a host of implementing subsidiary rules. If the fiduciary duties are breached, both R.M. Stark & Co., Inc. ( RMST ) and the RR could be liable for (1) compensatory damages to offset losses incurred or to make up gains foregone due to the breach; (2) disgorgement by the fiduciary of any profit accruing from the breach, or compensation paid by the principal; and/or, (3) punitive damages. A flat fee-based relationship places the investor and RR on the same footing. Each gains if the assets grow, and each suffers financially should the assets diminish. Any conflicts of interest that could arise in a non-fee based account due to the amount of compensation are eliminated. In addition, fee-based accounts provide valuable services not generally offered within commission accounts. RRs may offer both fee-based compensation and commission accounts. In the case of those customers for whom fee-based accounts are appropriate, RMST RRs can offer the RMST Wealth 23

24 Allocation Flex Account. The Flex Account is a wrap-fee program offering a structured investment program including a customer Risk Assessment, Asset Allocation Recommendations, Securities Recommendations, Quarterly Performance Reporting, Market Commentaries and Ongoing Monitoring and Rebalancing Recommendations. The program is non-discretionary. RMST RRs jointly registered with SFA may also offer the SFA Wealth Allocation Program and the Pershing/Lockwood Managed 360 program. Each of these discretionary programs are feebased within which wrap-fee covers advisory services, execution services, and custody. Registered Investment Adviser registration is required to offer these programs. 24

25 Portfolio Construction A fiduciary has the duty to make recommendations that are in the best interest of a retirement investor. It is generally accepted that recommendations in the best interest of a retirement investor must consider the investors age, expected cash distributions, long-term goals and expectations, and short-term attitudes. Tried-and-true portfolio principles demand that portfolios be constructed in a manner that reflects the investor s specific circumstances and incorporates risk-reduction features such as: proper asset allocation; appropriate diversification within an asset class; and, specific investments that are in the investor s best interest. Asset classes that should be considered for inclusion in all portfolios include: domestic stocks; non-us stocks; bonds; cash; real estate; and, commodities. As all asset classes have specific risk/return characteristics, proper asset allocation can reduce risk and enhance return. Many of the products offered by R.M. Stark & Co, Inc., Stark Financial Advisers, Inc., and Lockwood Advisers incorporate all of the above features and will help to assure we are properly executing our fiduciary duties. If you will be recommending an approved product that does not incorporate these features, it will be the financial adviser s responsibility to assure these benchmarks are met. Certain recommendations, such as target date funds and asset allocation funds, incorporate at least some of these features and may be a suitable investment. However, if you are recommending approved investments other than those mentioned above, you will need to invest in a suitable planning product that can assist with your investment planning. One of the most popular is Morningstar Office. Morningstar products can be integrated with Pershing s system making it easier to construct new portfolios and monitor existing ones. For information on Morningstar products, contact either Morningstar directly, or the Home Office. The appropriate asset allocation is specific to each client and changes over time. Changes in the client s circumstances, or attitudes, as well as valuation changes in various asset classes, are all items to be monitored. Periodically, most portfolios will need to be rebalanced. Following are several hypothetical asset allocation models that would be appropriate under current market conditions. As you can see, most of the hypotheticals include at least some of the same asset classes. However, the allocation percentage changes based upon risk tolerance and investment horizon. Generally, as an investor ages, the risk exposure should go down. As the risk level decreases, you would also anticipate a reduction in return. Hypothetical One Age 45 and Under Moderately Aggressive Risk Tolerance Asset Class % Allocation Mid-cap Domestic Stocks 54% Emerging Market Securities 13% High Yield Bonds 18% 25