The stakes on providing fi duciary counsel just went up. The playing fi eld is leveled by the Pension Protection Act of 2006 for RIAs, Brokers, Bank Trust Offi cers, Insurance Agents and Brokers of all types (Independent, Wirehouse and Regional) as fi duciary responsibil-ity unifi es everyone around a common fi duciary obligation.

Everyone who would like to act in their clients best interest and acknowl-edge they are acting in a fi duciary capacity must take note of what is re-quired as a fi duciary as you have a materially different relationship with your clients than you would in an industry historically structured to support commission sales. Now advisors have fi duciary obliga-tions to fulfi ll whether we have discretion (perhaps a Certifi ed Fiduciary Advisor) over our client’s as-sets or not (a Fiduciary Advisor provid-ing non-discretionary advice).

The penalties of misrepresentation are great. When an advisor is acting in a fi duciary capacity advising a client on investment matters, self dealing or enriching ones self at the expense of plan participants, is a prohibitive trans-action, subject to a penalty of 5% of the amount involved for each year the prohibited transaction continues, up to a maximum of 100% if not corrected

Pension Protection Act of 2006 Introduces Two Types of Fiduciary Advisors and an Audited Prudent Investment ProcessStephen C. Winks

within ninety days after notice from within ninety days after notice from the DOL. In addition the disqualifi ed the DOL. In addition the disqualifi ed person who is enriching ones self must person who is enriching ones self must pay a 15% excise tax on the amount pay a 15% excise tax on the amount involved up to 100% if not corrected involved up to 100% if not corrected within a certain time frame.

WHO IS A FIDUCIARY? WHO IS A FIDUCIARY?

Fiduciary responsibility is univer-Fiduciary responsibility is univer-sally applicable whether you are: (1) sally applicable whether you are: (1) a RIA under the Investment Advisors a RIA under the Investment Advisors Act of 1940 or under state law; (2) a Act of 1940 or under state law; (2) a

bank or similar bank or similar fi nancial insti-fi nancial insti-tution super-tution super-vised by the vised by the United States United States or a State, or or a State, or a Savings As-a Savings As-sociation (de-sociation (de-fi ned by the fi ned by the FDIC) but FDIC) but only if advice only if advice is provided by is provided by a Trust De-a Trust De-

partment that is subject to a periodic partment that is subject to a periodic examination and review by Federal examination and review by Federal and State banking authorities; (3) and State banking authorities; (3) an insurance company qualifi ed to an insurance company qualifi ed to do business under State law; (4) a do business under State law; (4) a registered broker/dealer under the registered broker/dealer under the Securities and Exchange Act of Securities and Exchange Act of 1934; (5) an affi liate of any of the 1934; (5) an affi liate of any of the preceding; (6) an employee, agent, preceding; (6) an employee, agent, registered representative of any of registered representative of any of the preceding who satisfi es the re-the preceding who satisfi es the re-quirements of applicable insurance, quirements of applicable insurance, banking and securities laws pertain-banking and securities laws pertain-ing to the provision of advice; (7) a ing to the provision of advice; (7) a

Summer 2006Summer 2006

Now advisors have fiduciary obligations to fulfill whether we have discretion (perhaps a Certified Fiduciary Advisor)

over our client’s assets or not (a Fiduciary Advisor providing non-

discretionary advice).

2

person/fi rm who develops an audited prudent process (computer model) ad-visory program or markets an audited investment advice program, which is treated as a fi duciary advisor.

You know you are a fi duciary if you (1) exercise any authority or con-trol with respect to the management or disposition of a plan’s (individual investor’s) assets, (2) render invest-ment advice for a fee or other com-pensation with respect to plan monies or property or have the authority to do so, or (3) have discretionary authority or re-sponsibility in the administra-tion of the plan.

WHAT IS A PROHIBITIVE TRANSACTION?

Prohibited transactions or self dealing with client as-sets at their expense, between an advisor and a plan sponsor include (1) the sale, exchange or leasing of property, (2) the lending of money or extension of credit, (3) the furnishing of goods, services, facilities, (4) the transfer to, or use by for the benefi t of, the in-come or assets of the plan, (5) any act that deals with the plan’s assets or in-come for the benefi t of the fi duciary, (6) the receipt by a fi duciary of any consideration for the fi duciary’s own personal account from any party deal-ing with the plan in connection with the income or assets of the plan (this is why fi duciary advisors relinquish their brokerage licenses and are fee only).

NON-DESCRETIONARY AUDITED PRUDENT PROCESS

The Pension Protection Act of

2006 provides exemptions to pro-hibitive transactions under ERISA and the Federal Tax Code in connec-and the Federal Tax Code in connec-tion with advisors providing advice through a non discretionary audited prudent investment process (“eligible investment advice arrangement”) to plan participants of defi ned contribu-tion plans who direct the investment of their accounts. To meet the require-ments, the advisor must either: (1) be a fee only advisor were compensation

is the same on all investment options so there is no compensation bias/con-fl ict in offering non discretionary ad-vice, OR (2) use a non discretionary audited prudent investment process (“computer advisory program model” authorized by the investor/plan spon-sor). An advisor who has discretion over client assets is by defi nition a fi duciary advisor.

If an audited prudent process (“computer model”) is preferred by the investor/plan sponsor, the non discretionary audited prudent invest-ment process (“computer model”) must: (1) apply generally accepted investment theories that take into account the historic returns of asset

classes over defi ned time periods, (2) use relevant information of the investor/plan participant, (3) use pre-investor/plan participant, (3) use pre-scribed objective criteria to provide asset allocation portfolios utilizing the investment options available, (4) operate in a manner that is not biased in favor of any investment options of-fered by a fi duciary advisor or related person, (5) take into account all in-vestment options with out inappropri-ate weighting of an investment option,

(6) an objective third party expert must certify that the computer model meets the requirements of the DOL (to be prescribed), (7) the only investment advice provided when utilizing a non discretionary audited prudent investment process (“computer model”) is that generated by the process (“model”), (8) any in-vestment transaction pursuant to the audited prudent investment process’s (“computer model’s”) advice is solely at the direction of the investor/plan participant

(9) the investor/plan participant may request further counsel but it can not be solicited by any person associated with the provider of the audited pru-dent investment process (“computer model”), (10) the audited prudent in-vestment process (“computer model advisory services program”) will be audited against DOL compliance cri-teria every year by an independent auditor and a written audit report will be provided to the DOL.

The audited prudent investment process is not an asset allocation model, it is large-scale institutional-ized support for fi duciary counsel based on statute, case law and regu-latory opinion letters. The advisor is

The Pension Protection Act of 2006 provides exemptions to prohibitive transactions

under ERISA and the Federal Tax Code in connection with advisors providing advice

through a non discretionary audited prudent investment process (“eligible investment

advice arrangement”) to plan participants of defined contribution plans who direct the

investment of their accounts.

3

required to act in the best interests of the investor (as a prudent expert if the advisor has discretion over their the advisor has discretion over their clients assets) fully disclosing all ac-tivities and forms of compensation in order to fulfi ll their fi duciary ob-ligations. A six fi nancial services in-vestment process is required which is comprised of (1) the asset/liability study, (2) investment policy, (3) stra-tegic asset allocation, (4) manager search and selection, (5) performance monitor, (6) tactical asset allocation. Several elements of these six fi nan-cial services can be combined. The asset/liability study, invest-ment policy, strategic asset al-location are often combined in investment policy. Each of the six fi nancial services adds value in its own right, but when ag-gregated into to an audited pru-dent process they constitute an extraordinary level of continu-ous (real time) comprehensive counsel. Think of each of the six fi nancial services as entailing approx-imately forty activities that are the subject of the fi duciary audit that is required in an audited prudent invest-ment process. For an in depth expla-nation the prudent investment process based on statute, case law, regulatory opinion letters and best practices see SENIOR CONSULTANT Decem-ber 2005, “The Society of Fiduciary Advisors Fiduciary Investment Stan-dards Initiative Best Practices For Individual Investors. You will note eighty percent of what is required for an audited prudent process is disclo-sure and reporting related that readily lends itself to automation, so much of the detail that must be managed can

be automatically embedded into an audited prudent investment process. Thus by virtue of working within an Thus by virtue of working within an audited prudent process—the DOL has facilitated the creation of a mech-anism where the advisor is automati-cally fulfi lling their fi duciary respon-sibilities without having to manually manage an extraordinary degree of detail for a very large number of ac-counts. An audited prudent process, by defi nition, will change pricing, reporting and operations of the indus-try as a different relationship with the

consumer is required and cost decline by virtue of transparency, disclosure and the advisor acting as a prudent expert on the client’s behalf.

CERTIFIED FIDUCIARY ADVISOR

Fiduciary Advisors using a non-discretionary audited prudent invest-ment process cannot provide advice beyond that generated by the com-puter model, thus establishing a very high minimum threshold for advice that will impact the industry at large. The non discretionary advice pro-vided by a fi duciary advisor does not require the advisor to act as a prudent expert as the investor/plan participant may choose to follow the advice pro-

vided or not, effectively letting the advisor off the accountability hook. That is not the case with advisors that That is not the case with advisors that have discretion. The fi duciary advisor who has discretion over client assets must act as a prudent expert and is ac-countable for their recommendations. Thus we have two types of fi duciary advisors, one is a prudent expert the other isn’t, one has discretion, the oth-er doesn’t, one is held accountable for their recommendations, and the other isn’t. The non-discretionary advisor’s counsel is limited to the intellectual

capital imbedded in the audited prudent process within which they work. The discretionary advisor is required to act as a prudent expert and must manage issues like the outsourcing and/or management of trading cost, investment strategy and tactics for continuous comprehensive counsel, real time management of a high degree of portfolio de-tail as required by client direc-

tive (and regulatory mandate), etc. The non-discretionary advisor is to a discretionary advisor like an accoun-tant is to a CPA. The industry must create a certifi cation that establishes the expert status of the Certifi ed Fidu-ciary Advisor to accompany the DOL certifi cation of the Audited Prudent Investment Process they use. The So-ciety of Fiduciary Advisors (which has defi ned advice based on statute, case law, regulatory opinion letters, best practices, process, procedures, work fl ow and task and has defi ned the en-abling resources necessary to act as a prudent expert in providing fi duciary counsel so that advice can become scalable) is exploring the sponsorship

Thus by virtue of working within an audited prudent process—the DOL has facilitated the creation of a mechanism where the advisor is automatically fulfilling their

fiduciary responsibilities without having to manually manage an extraordinary degree

of detail for a very large number of accounts.

4

of/development of a six sigma train-ing course and an associated audited prudent investment process in which an advisor/CEO, their Chief Admin-istrative Offi cer and Chief Investment offi cer can achieve black belt status in collectively acting as a prudent ex-pert by market segment (mass, retail, HNW, Ultra HNW, defi ned contribu-tion, defi ned benefi t, public funds, profi t sharing plans, foundations and endowments, Taft-Hartley plans) and/or in an advisor/CEO outsourcing the CAO/CIO functions so the advisor act-ing alone can act as a prudent expert.

FIDUCIARY ADVISOR DIS-CLOSURE STATEMENT

In order for the DOL to pro-vide the fi duciary advisor an exemption in providing non discretionary advice to the in-vestor/plan participant, the fi -duciary advisor (1) must use a disclosure statement; (2) any investment transaction must be non discretionary occurring solely at the direction of the recipient of advice; (3) compensation received by the fi duciary advisor and/or affi li-ates must be reasonable; (4) the terms of the investment transaction must be at least as favorable to the plan as an arm’s length transaction would be. Before any advice is rendered, the fi duciary advisor is required to use a disclosure statement that must include information relating to: (1) the role of any related party in the development of the investment advice program or the selection of investment managers under the plan; (2) past performance and rates of return for each invest-ment option offered under the plan;

(3) any fees or other compensation to be received by the fi duciary advisor or affi liate (to include brokerage fi rm or custodian); (4) any material affi lia-tion or contractual relationship of the fi duciary advisor or affi liates in the security or other property involved in the investment transaction (this is why RIAs relinquish their brokerage license); (5) the manner and under what circumstances any participant/investor information will be dis-closed; (6) the types of services pro-vided by the fi duciary advisor in con-nection with the provision of advice;

(7) the advisors status as a fi duciary of the plan/investor in the provision of advice; (8) the ability of the recipi-ent of advice to separately arrange for additional advice from another advi-sor who has no material affi liation with and has not received compensa-tion in connection to the advice previ-ously rendered. The DOL will publish a model form of disclosure for fi du-ciary advisors.

DOL FEASIBILITY DETERMINA-TION OF AN AUDITED PRU-DENT PROCESS

The DOL will solicit at least the top 50 trustees of individual retire-

ment accounts by assets on the fea-sibility of providing a non discre-tionary audited prudent investment process (“computer model advisory program”) for plan participants. The non-discretionary audited investment process (“computer model advisory program”) must (1) use relevant in-formation about the investor/plan par-ticipant; (2) take into consideration the full range of investments and (3) allow the investor/plan participant suffi cient fl exibility in obtaining ad-vice to evaluate and select investment options. If the top 50 trustees do not

respond within sixty days from the DOL inquiry, they loose the opportunity to have an exemp-tion in providing advice to plan participants/investors and a sig-nifi cant marketing advantage in selling their services, thus the timely response of the industry’s top plan trustees is very likely. Any person may request the DOL to make a determination of whether their audited prudent

process (“computer model invest-ment advice program”) can be used with plan participants. The DOL must make that determination within 90 days of the request. If the audited prudent investment process (“com-puter model”) can not be used, with-in ten days of the determination the DOL must report the reasons for the determination to (1) the House Ways and Means Committee, (2) the House Education Committee, (3) the House Workforce Commit-tee, (4) the Senate Finance Commit-tee, (5) the Senate Health, Education and Labor Committee, (6) the Senate Pensions Committee.

Any person may request the DOL to make a determination of whether their

audited prudent process (“computer model investment advice program”) can be used

with plan participants. The DOL must make that determination within

90 days of the request.

5

If the DOL determines that a non discretionary audited prudent in-vestment process (“computer model advisory services program”) is not deliverable, then it will grant a class exemption from prohibitive transac-tion treatment for (1) the provision of advice by a fi duciary advisor to plan participants/investors; (2) investment transactions pursuant to advice; (3) the direct or indirect receipt of fees or other compensation in the con-nection with the provision of advice or an investment transaction pursu-ant to advice. This class exemption requires the fi duciary advisor to: (1) adopt written policies and procedures that ensure the advice provided is not biased in favor of investments offered by the fi duciary advisor or a related person; (2) appoint an individual re-sponsible for annually reviewing the advice provided to determine that the advice is provided in accordance with the policies and procedures cited above.

If the DOL determines that there is any non discretionary audited pru-dent investment process (“computer model”) that can be used by plan participants/investors, the class ex-emption expires at the later of: (1) the date two years after the DOL deter-mination or (2) the date three years after the exemption fi rst took effect or August 17, 2006 the effective date of the enactment. This means it is highly likely that trustees of retirement plans must provide access to a non discre-tionary audited prudent investment process by August 17, 2009, if they are to be competitive in helping plan participants with investment advice.

Of course, from a competitive stand-point—the sooner the better.

WHAT DOES THIS MEAN?

1. All advisors (RIAs, Bankers, Brokers, Insurance Agents) are united under one universal crite-rion for fi duciary counsel.

2. Whether or not an advisor has discretion over their client’s as-sets, they have fi duciary obliga-tions.

3. Money managers cannot help plan participants with advice.

4. Non-discretionary advice offered by a fi duciary advisor is differ-ent from discretionary advice offered by a fi duciary advisor, as the latter is required to act as a prudent expert.

5. An audited prudent investment process will be developed and/or advanced by all plan trustees no later than August 17, 2009, or they loose the opportunity to provide plan participants ad-vice—a highly valued consider-ation by plan sponsors and par-ticipants alike.

6. The minimum threshold for ad-vice generated by a non-discre-tionary audited prudent invest-ment process will become the new base point standard for ad-vice for all consumers to include individuals.

7. Prudent expert fi duciary counsel will become the ultimate differ-entiation for advisors, requiring the expert management of cost, data and technology on behalf of the consumer for an advisory

fee. All cost will be negotiated on behalf of the consumer and will be made transparent. Any intermediary parties or vendors to advice that do not add value and/or cannot be held to the terms required/negotiated by a prudent expert on behalf of the consumer will become out dated as cost are compressed and fully disclosed. The advisor’s mar-gins and value proposition are optimized, while the consum-er’s cost comes down by virtue of the fi duciary advisor acting as a prudent expert on behalf of the consumer. All cost are fully disclosed making them trans-parent and readily negotiable by the advisor as a prudent expert.

8. Trading costs are managed as a cost center, not a profi t center. Prudent expert negotiation with Electronic Crossing Networks will establish trading cost and with scale negative trading cost environments will emerge as a major point of differentiation in a fully transparent audited pru-dent investment process. (See SENIOR CONSULTANT July 2004, “The Third Rail Of The Financial Services Industry: Trade Execution, Best Execution and Beyond)

9. Real time access to data neces-sary for the continuous com-prehensive counsel required by regulatory mandate will require direct real time access to client holdings which will drive de-mand for the intellectual capi-tal of managers in the form of

6

real time buy/sell research un-real time buy/sell research un-bundled from account adminis-bundled from account adminis-tration. This is known as model tration. This is known as model portfolios, which in turn will be portfolios, which in turn will be managed by, overlay manage-managed by, overlay manage-ment technology. Asset man-ment technology. Asset man-agement cost drops to 18 to 25 agement cost drops to 18 to 25 basis points, repetitive triplicate basis points, repetitive triplicate account administration done at account administration done at the advisor, manager and trust-the advisor, manager and trust-ee levels that adds no value is ee levels that adds no value is just done once, an extraordinary just done once, an extraordinary level of account detail can be level of account detail can be managed in real time (which managed in real time (which is not possible if you have to is not possible if you have to manage through mutual fund manage through mutual fund packaging or managed account packaging or managed account sleeves), the fi duciary advisor sleeves), the fi duciary advisor fulfi lls their fi duciary obliga-fulfi lls their fi duciary obliga-tion as a prudent expert acting tion as a prudent expert acting in their clients best interests. in their clients best interests. (The DTCC’s announcement (The DTCC’s announcement of a common communications of a common communications protocol for managed accounts protocol for managed accounts on September 6th is a major is a major technological breakthrough that technological breakthrough that takes the industry closer to real takes the industry closer to real time information confi rming the time information confi rming the DOLs insistence that the indus-DOLs insistence that the indus-try embrace modern technol-try embrace modern technol-ogy. The DTCC has access to ogy. The DTCC has access to real time data on virtually all real time data on virtually all transactions, and can make data transactions, and can make data available on a one day-delay ba-available on a one day-delay ba-sis with the ultimate objective sis with the ultimate objective of making real time data avail-of making real time data avail-able. Until then model portfo-able. Until then model portfo-lios with overlay management lios with overlay management are the only vehicle that facili-are the only vehicle that facili-tates the real time management tates the real time management of the extraordinary degree of of the extraordinary degree of portfolio detail required.)

10. Real time analytics empower the fi duciary advisor to be a pru-dent expert advising the inves-tor/plan participant in real time anything they would want to know about their portfolio with strategic and tactical insight. (See SENIOR CONSULTANT July 2004, “The Web Effect: Reinventing The Financial Ser-vices Industry And Its Pricing By Democratizing Access).

11. Asset management changes in fundamental ways for the good of the investing public as access to faster; better, cheaper ap-proaches to providing expert fi -duciary counsel are introduced.

The Pension Protection Act of 2006 is the most profound pension legisla-tion since the passage of ERISA, 32 years ago. PPA 2006 not only updates pension legislation but also refl ects an entirely different business environ-ment. Technology and expert systems are embraced that empowers the fi du-ciary advisor to electronically man-age an extraordinary degree of port-folio detail for an unlimited number of portfolios that goes far beyond the human capacity to reason. The fi du-ciary advisor is empowered to deliver an unprecedented level of investment and administrative counsel that could not have been envisioned 32 years ago. PPA 2006 goes a long way in bringing the investment/advisory in-dustry into the twenty-fi rst century, greatly elevating the role and counsel of the advisor. ◆◆◆

NOTES NOTES