Step 4 of the Fiduciary Process: Monitoring the Client Engagement

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2 Step 4 of the Fiduciary Process: Monitoring the Client Engagement Rich Lynch Fi360 & CEFEX, Director

3 Topics Quantitative and qualitative reviews Fees and expenses Fiduciary reviews

4 Survey Question #1 WHAT IS YOUR MOST DIFFICULT HURDLE WITH RESPECT TO MONITORING FEES AND EXPENSES? Determining who s getting paid and how much 30% Determining whether the compensation is reasonable 48% Ensuring that compensation is consistent with governing documents (i.e., IPS), policies and procedures, and service agreements 22%

5 Survey Question #2 FOR THOSE CLIENTS WHERE YOU HAVE ASSUMED RESPONSIBILITY FOR THE OVERSIGHT OF OTHER SERVICE PROVIDERS, WHEN WAS THE LAST TIME A SERVICE PROVIDER (INCLUDING YOU) WAS REPLACED? N/A 36% Within 3 years 38% Never 12% Within 5 years 14%

6 Process, Not Performance A fiduciary s conduct is measured by the process employed, not by the investment outcomes obtained. Fiduciary excellence is prudent processes, consistently applied.

7 Fi360 s Prudent Practices Legal Substantiation from: ERISA: Employee Retirement Income Security Act (Qualified retirement plans) UPIA: Uniform Prudent Investor Act (Private trusts, the default standard if nothing else fits ) UPMIFA: Uniform Prudent Management of Institutional Funds Act (Foundations, endowments, and government sponsored charitable institutions) UMPERSA: Uniform Management of Public Employees Retirement Systems Act (State, county, and municipal retirement plans) IAA: The Investment Advisers Act of 1940

8 Global Fiduciary Precepts 1. Know standards, laws, and trust provisions 2. Diversify assets 3. Prepare investment policy statement 4. Use prudent experts and document due diligence 5. Control and account for investment expenses 6. Monitor the activities of prudent experts 7. Avoid conflicts of interest

9 The Fiduciary Quality Management System (FQMS)

10 Duty to Monitor Substantiated in ERISA, Advisers Act, UPIA, UPMIFA, UMPERSA Represents one of the most important obligations of fiduciaries Ongoing obligation of fiduciaries that can t be completely delegated Encompasses all other practices, assures continual improvement Plays a crucial role in mitigating regulatory, litigation, and reputational risks

11 Step 4 Monitor Quantitative and qualitative reviews Fees and expenses Fiduciary reviews

12 Quantitative Reviews Include comparison of each fund s or investment manager s performance against: Appropriate index Peer group results Performance objectives stated in the IPS

13 Performance Monitoring Frequency Factors that influence frequency of performance monitoring: Specified fiduciary requirements The size of the investment program The investment strategies employed The sophistication of the investment program The volatility of the investments selected The general economic and market conditions then prevailing

14 Present the Performance Report Describe: Changes in the landscape, e.g., objectives, the economy, the market, laws or regulations, etc. Market returns Review the plan investment menu Progress towards investment objectives Manager performance compared to peers and benchmarks Action needed

15 Qualitative Reviews Periodically review qualitative information such as: Staff turnover Organizational structure Level of service provided Quality of reports Quality of responses to requests for information Investment education Headlines

16 Duty to Act on Adverse Information Evaluate: How serious? What is the organization s response? Decide: Make a change: Are there alternative investment options? What is the fund family fiduciary ranking? Leave things alone Document rationale either way

17 Control and Account for Investment Expenses Plans must evaluate and account for investment related fees, compensation, and other plan expenses [which were disclosed in 408(b)(2) disclosures]. Other institutional accounts (i.e., endowments and foundations) should provide 408(b)(2) type disclosures as well. Expenses must be reasonable considering the scope of services provided. Area of intense scrutiny from lawsuits and regulators.

18 Who is Being Paid? Investment Manager Fees and/or annual fund expenses Trading or processing costs (i.e., commissions, soft dollars, directed brokerage, and 12b 1 fees) Custodial charges custodial fees and transaction charges Consulting, recordkeeping, and administrative costs Money Manager Custody Record Keeping Execution Brokerage Consultant Finder s Fee

19 Mutual Fund Expense Structure Regulatory expense ratio (RER): Management fees Rule 12b 1 fees Other expenses Additional expenses not reported: Brokerage commissions (avg. approx. 40 bps) Implicit trading costs (avg. approx. 50 bps)

20 Red Flags Under ERISA Excessive Fees: Excessive fees of service providers (including advisors) the current focus of DOL investigations and plaintiff lawsuits Fees must be reasonable and necessary to defray costs of running the plan Revenue Sharing: Revenue sharing by services providers not prohibited under ERISA Revenue sharing must not be used to offset other plan sponsor/corporate services Revenue sharing could result in a prohibited transaction if it causes excessive compensation to be paid to service providers.

21 Service Agreements and Fees Fiduciary obligation to control and account for investment expenses. Investment manager fees vary based on: Asset class Account size Investment vehicle Performance based fees: Performance based fees are not permitted in all states and, where permitted, are subject to 80b 5 (a b) of the Investment Advisers Act of 1940.

22 What is Fair and Reasonable? Can the fees be paid from portfolio or plan assets? Are the fees reasonable in light of the services to be provided? Do the fiduciaries have market data for similar plans, in order to compare the services and the fees? Have the fiduciaries evaluated the fees of each service provider in light of the quantity and quality of services being offered? Range Frequency of contact Participation/contribution rates Investment returns

23 Fiduciary Assessment Recommended schedule: Monthly review custodial statements Quarterly review overall portfolio and individual investment performance Annually review IPS, service providers, and your own fiduciary performance Every three years revisit vendor contracts Impromptu reviews as circumstances dictate

24 The Process of Monitoring Apply an evidence based approach: Gather the facts Analyze the facts Act on your findings: Corrective actions Watch list Document your actions: Demonstrates procedural prudence Provide precedents for decision making

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