New Tools to Prove You Acted as a Fiduciary

SEI: The big picture

As we survey the various pieces of this fiduciary puzzle, let’s start with the big picture. The most comprehensive tool to help an RIA shift from commissions to fiduciary compliance is the new DOL Action Plan template created by SEI. The template can be used as a guide to transitioning your business, and then as a series of implementation workflows incorporated into the Redtail CRM system. “Ninety percent of our advisor clients are affiliated with broker-dealers,” says Lee. “They have some basic business decisions to make between now and April 10.”

The SEI template recommends that commission-compensated advisors start the daunting shift in their business model by segmenting their consumers. “For certain accounts, we believe it might make sense to obtain a BIC exemption, and continue to serve those clients on a commission basis.” says Lee. “With others, you’ll want to move to a level-fee relationship, changing the compensation from commissions to a level-fee arrangement. And the third option – and the more we get into this, the more we believe this is not going to happen very often – is the concept of orphaning.”

Orphan accounts are those which you want to give up, because the shift from a transactional to an ongoing service relationship is not cost-effective. “If you have accounts where the cost of overhead and servicing and providing advice makes them no longer viable,” Lee explains, “then you might decide to tender them your advisor resignation letter and let them move to Vanguard or some other provider.”

Once you’ve segmented your client base, you enter the execution phase: meeting with clients, executing transactions that move clients out of commission-based investments to AUM accounts, sending letters to clients informing them that you will be acting as a fiduciary going forward, resigning from engagements, and getting the broker-dealer’s BIC exemptions lined up for accounts where you still intend to make product recommendations for a commission.

“We believe that all of this should be managed in the advisor’s CRM,” says Lee. “So we created different workflows that can be uploaded into Redtail. If you’re not a Redtail user, then it’s possible to do these things manually, but you want to keep track of everything using some sort of system.”

The workflows feed off of the segmentations. Using Redtail, you code each client according to how they will be handled in light of the DOL rule, and then create a schedule of actions. For example, for those who will be moved from a transaction-based to a fee-compensation relationship, the workflow (see graphic) will start with the client service associate preparing client communications and coordinating a meeting with the client. Then the associate advisor will prepare the paperwork and other deliverables. The advisor reviews the paperwork and presents it to the client. Follow-up tasks like collecting the signed account forms and disclosures, managing the opening of new fee-compensated accounts and assigning appropriate investment strategies are then handled by the client service associate and associate advisor.

Redtail tracks when each client meeting is upcoming and SEI’s Action Plan provides a template that lists all the issues that you and the client will need to discuss. Redtail keeps a record of all the meetings that were held, any notes you’ve made about what was discussed and a copy of your summary letters to clients. It also tracks the paperwork in progress. Was the fee agreement sent to the client? Did the client sign and return it? Has the client received the latest ADV and privacy offering? When is the next review date?

“There’s a standard Redtail mantra that says: if it’s not in the CRM, then it didn’t happen,” says Lee. “That is especially true when there are regulatory reasons to keep track of who you contacted and how, and the actions you took.”

The SEI DOL Action Plan Template includes a white paper that outlines how a firm can manage the process of preparing for the DOL rule administratively, plus four documented workflows that can be used outside or inside Redtail, plus an instructional video.

“Our goal was threefold,” says Lee. “First: to help you organize how you’re going to proceed. Second: Once you have a solution, make sure it gets implemented. Finally,” he says, “if you need to justify what you did for compliance purposes, how can we make it easy for you to access that information?”

Cost? SEI’s DOL tools are complimentary to the profession.

Ann Schleck: Are your rollover fees reasonable?

When you’re evaluating whether a client would be better off with a rollover that your firm will manage, an important issue is cost. Are you saving the client money, all-in, by moving assets from one account to the other? Are your fees reasonable? Is the client getting more service in return for paying your fee?

The most comprehensive fee-related DOL tool is a new product created by Ann Schleck & Co. in Woodbury, MN – a subsidiary of the Pittsburgh, PA-based fi360 organization. Schleck is a longtime practice management consultant to advisors in the qualified plan space. In that capacity, she developed a tool called Fee Benchmarker, which illustrates how much is being charged to plan participants by 260 different firms that specialize in providing investment advice for qualified plans around the country.

“The question that Fee Benchmarker was designed to answer is: What are different advisors around the country charging for their services to plans of different sizes, and are we competitive with those fees?” says Robin Green, the company’s head of research. “It looks at the various services that are offered, and the plan sizes, and it gives ranges and averages, so the advisor can see if he or she is in line with the market.”

The reports show the average annual fee that all the various advisors are charging for the particular plan size, and the median fee and the fee range broken out into quartiles, highest to lowest. It lists the average services that are provided to plans of similar size, and a percentage of firms that provide additional services like offering participant educational meetings or taking on the extra liability of acting as a 3(38) fiduciary, (where the advisory firm has discretion over the assets that go into the plan, so that instead of performing oversight over the investments, the plan sponsor only has to monitor the advisor.

Right now, this is not an interactive digital solution. Scheck’s still-to-be-named IRA rollover solution, which will be on the market sometime in the Spring, will leverage this database. That tool will provide a comparison of the all-in expense of both options, and the advisory fees can also be compared with industry standard fees for 401(k) portfolios.

“Regardless of what the industry benchmark is,” says research consultant Andrew Ziolkowski, “we believe that the advisor should say: You’re currently paying 120 basis points for your retirement plan in this legacy 401(k). The IRA that I’m proposing would be 80 basis points, all-in, and here’s what you get for that compared with what you’re getting now.”

Cost? To be determined.

Morningstar: Compare expenses and expected performance of rollover portfolios

If a rollover is being made in the client’s best interests, then cost is obviously not the only factor to consider. A key part of the assessment is whether the new portfolio will be superior to the old one.

This is the focus of Morningstar’s new DOL tool, tentatively called Best Interest Scorecard as it moves toward a launch date in February. The goal is to make it easier for advisors to analyze the quality of a client’s 401(k) portfolio and compare it with their proposed one.

Analyzing qualified plans has not been where Morningstar’s traditional expertise lies, so the firm has purchased a data analytics firm called Right Pond, along with its database of the information on the 5500 tax forms that qualified plans have to provide to the IRS. “We’re integrating that information with our fund database,” explains Trish Rothschild, Morningstar’s head of global wealth management solutions. “And we also have access, through ByAllAccounts, to the fund lineups that are available in the plans the advisor is evaluating.”

When you log into Morningstar’s DOL tool, the account aggregation plus Right Pond data will give you a list of the funds the client is invested in, and their percentages. The 5500 forms also help determine the costs of the plan, and Morningstar’s database provides the expense ratios and performance of the individual funds.

When advisors run a comparison with their proposed portfolios, the tool will look not just at the 401(k) funds the client has invested in, but also at other possible investment combinations available in the plan. “We feel that it’s important for the advisor to ascertain whether, regardless of what the investor has selected for her 401(k) account today, the lineup offers better options that she could be invested in,” says Amy Ost, Morningstar’s senior project manager who is handling the DOL tool’s development. “The advisor needs to be able to show that the proposed IRA portfolio is not only superior to the funds the client has selected, but is also superior to potentially better portfolios that are available if the client had the advice of an advisor.”

The system also asks you to list the services you plan to provide if the money is rolled over to an IRA, compared to the list of services currently provided through the plan. Part of this process involves a checklist where the client checks boxes indicating the services he/she is particularly interested in. This could include savings guidance and advice, consistent portfolio rebalancing, planning for income in retirement, estate planning and home buying advice.

Finally, Morningstar integrates with MoneyGuidePro and eMoney, and is working on a NaviPlan integration, which will make it easy for you to import the future cost of a client’s financial goals.

With these inputs, the Morningstar DOL tool produces a report, which can be archived in your compliance files, comparing the current 401(k) options with the proposed IRA rollover in five different dimensions:

1. The fees and expenses, fund-quality ratings and expected performance of the 401(k) options versus the proposed portfolio.

2. The asset allocation of the proposed portfolio versus the existing options.

3. Any differential in services provided under the existing and proposed arrangement.

4. Once the client’s future financial goals are imported, how likely is it that each portfolio will meet those goals given the client’s risk tolerance?

5. Are there other issues to consider, like the financial health of the plan sponsor, appreciated employer securities in the plan or differences in withdrawal accessibility between one option and the other?

The new tool is still under development, which means the final scorecard hasn’t been graphically designed. Rothschild says that it will also include a tool that lets advisors document another type of recommendation that doesn’t fall under the DOL rule.

“We’re building a way to evaluate whether it would make sense for a client to move fund or ETF assets into a single-premium immediate annuity (SPIA) or a variable annuity with an income guarantee,” Rothschild explains. “The system will be able to make decisions about where we draw from each year. In the annuity scenario,” she says, “the client would have the choice to draw from the variable annuity to the extent the guaranteed income is protected, or to withdraw from the traditional assets, and factor in Social Security. Then we compare outcomes and show the tradeoffs, which is that your income might not be as high if you buy the annuity, but ultimately you have a floor of income that lasts throughout your life.”

Meanwhile, the scorecards and analyses can all be monitored by compliance personnel at the broker-dealer’s home office. “With the DOL rule and the expectation that advisors will act in the best interests of the client,” says Rothschild, “it puts the compliance department on the hook to set up a process that the advisors will follow so that both the firm and the advisor can comply with the best interests standard. We’re giving them a way to monitor how their RIAs are going through the steps to determine and document that the recommendations really are in the best interests of the client.”

fi360: Ensuring portfolios meet your IPS on an ongoing basis

If you want to come at the process of exploring a rollover from a slightly different angle, consider the Fiduciary Focus Toolkit from fi360. The Toolkit starts with the assumption that as the DOL rule causes the ERISA standards to encroach on the retail advisor space, more advisors will start adopting ERISA practices. With the Toolkit, this starts with an investment policy statement (IPS), where you specify how you’ll create a new portfolio for the client, and more importantly (this is the key angle) how you’ll monitor those investments on an ongoing basis. Then it automates and simplifies the complex task of determining whether funds continue to meet to your standards – or not.

The IPS tool is basically a mail-merge template with boilerplate language for different types of clients – qualified plans (were the advisor acts as a 3(21) or 3(38) fiduciary), trusts or individual investors – that you can customize. You check boxes that determine whether different paragraphs will be included in the client’s final draft. A broker-dealer can share the templates across a broad range of affiliated advisors, and control the level of modification that is allowed.

These templates also have sections that pull data from the fi360 investment database – known as “system fields.” “The best example is your watch list criteria,” explains John Faustino, fi360’s chief product and strategy officer. “We have a best practice watch list process that many advisors use,” he adds, which includes a proprietary fiduciary score that is an amalgamation of a variety of factors: expenses lower than the 50th percentile, returns above the median for various long-- and short-term time periods, manager tenure longer than five years, whether the fund share class has sufficient AUM in it to be liquid, whether the fund exhibits style drift, positive alpha and an acceptable Sharpe ratio. The funds with the highest scores are coded dark green; the next quartile is coded light green, and the next two are amber and red, respectively.

You can set your own criteria for which of these metrics causes a fund to roll onto your watch list, but the general default is to call your attention to any fund that falls from green status to amber or read for the most recent quarter, and keeps the fund on the watch list until/unless it returns to the upper half of fund fiduciary scores. (See graphic for a client-facing explanation of a fund’s fiduciary score.)

Another system field is how far different allocations can move outside the percentages specified in the IPS before they’re rebalanced.

The system field criteria that you specify in the IPS will automatically populate a database that allows you to monitor your clients’ holdings. The system will alert you whenever a portfolio falls outside the tolerances, and automatically put funds on a watch list.

From the Fiduciary Focus Toolkit dashboard, you can look at the holdings of each individual client – or, if you use model portfolios, you can call up all of your investment holdings and sort them to see which are currently on the watch list. Click on the fund and you get a graph that shows, not return, but where the fund fell on the fiduciary score rankings each quarter. (See graphic.) So you might see that one fund slipped just below the 50th percentile over two consecutive quarters, but it has been steadily in the upper two quartiles for most of its history. Another fund on the watch list may have experienced periodic forays into the red zone, and has spent the most recent two quarters in that fund purgatory.

“We don’t automatically specify that a fund should be replaced,” says Faustino. “We believe that’s a qualitative judgment that the advisor should be making based on the facts and circumstances.”

If you decide to remove a fund from client portfolios, the Toolkit will help you search and screen for a replacement. You can, for example, search across mid-cap funds, looking for high average long-term fiduciary scores and perhaps lower expense ratios. Once you’ve whittled your search down to a handful of funds, you can investigate each of them and make your choice. The system will save your search criteria so you can document your process.

Cost? The Fiduciary Focus Toolkit costs $2,400 a year for each advisor using the tool – with discounts for multiple users.

In addition, broker-dealers can buy the system on a negotiated basis, and monitor all the IPSs and funds that its reps are investing in – and whether the watch lists and rebalancing triggers are being followed up on.

Smart Risk: Measuring the downside risk in portfolios

Now let’s look at a comparison of the 401(k) investments versus your recommended IRA rollover from another direction: Are you providing a less risky portfolio for your client?

A new rollover tool is being created by Prairie Smarts, the Omaha, NE-based company that markets the Smart Risk evaluation software. With Smart Risk, you can import a client’s portfolio holdings from Orion, Redtail or a spreadsheet, and the software will calculate your “downside expectation” – that is, the maximum potential loss in the portfolio – over a day, a week, a month or a year. “The idea is that the advisor would show the client how much the portfolio might be down, in dollar terms, over a single month,” says company co-founder Ron Piccinini. “Then you see if the client has a heart attack, or simply nods and says that this is about what he expected. In some cases, you might dial down the portfolio to the client’s comfort level.”

The software also provides a risk ratio, known in CFA circles as the omega ratio, which determines how much upside you get per unit of risk you’re taking. This is actually a numerical representation of the efficient frontier, where higher volatility portfolios generate more return per unit of risk than portfolios that sit nearer the left end of the curve. In a demonstration, Piccinini showed me a portfolio with an omega ratio of 2.18, meaning for each dollar the portfolio could lose during the next bear market, it can expect to make $2.18 back when the bulls finally start running again. Another portfolio, more conservatively invested, offered an omega ratio of 1.11.

The output also gives an “asset interaction” score that defines how diversified the portfolio is – or, in some cases, is not. “Some investors will select a lot of different funds in their 401(k),” Piccinini explains, “and they think they’re diversified. But when you look under the hood, you see that they’ve bought a lot of different versions of the same investment.”

Finally, there’s an evaluation similar to the traditional beta measure, which shows how the portfolio might react if the S&P 500 were to drop 10%, 20% or 30%. The software allows users to perform this evaluation on a dozen different indices, basically stress-testing the portfolio against different types of bear market.

How does this relate to the DOL rule and rollovers? Smart Risk is adding features which allow you to create a side-by-side comparison of a client’s existing 401(k) portfolio allocation with the model portfolio that you might be recommending. “Many of our customers are creating mock portfolios that they then edit and modify, so they can see if they can improve the key metrics,” says Piccinini. “Now they’ll be able to compare those same metrics with the client’s 401(k) holdings.”

The new tool will also make it easy for you to compare your proposed portfolio management costs with industry standards. “At the Orion Fuse conference, we piloted with a company called Price Metrix,” Piccinini explains. “They have a very detailed benchmark industry reference database for fees and for portfolio risk, so you can do your slicing and dicing based on demographics.”

Cost? Smart Risk costs $1,500 per user, with volume discounts for larger firms. In addition, an enterprise version, which allows a broker-dealer’s compliance officer to monitor proposed portfolios and risk metrics, costs anywhere from $5,000 to $35,000 a year, depending on the size of the firm.

Trade Warrior/Riskalyze: Mapping the trades

Another take on analyzing client risk capacity comes from Trade Warrior Software, the Layton, UT-based company that provides an advanced trading and rebalancing platform. When the DOL rule came out, Trade Warrior created an integration with Riskalyze, the client risk-tolerance assessment software that also categorizes portfolios based on their risk score.

“It’s easy for FinaMetrica (another risk tolerance assessment tool) or Riskalyze to say: your risk tolerance is 50, but your portfolio is a 78,” says Janson Evans, Trade Warrior’s chief sales executive. “The harder part is determining: exactly what trades do you need to make to dial the portfolio down to a 50?”

That’s what the new integration will do. Riskalyze defines the asset classes that the “50” portfolio would be invested in, and then Trade Warrior translates that allocation down to the specific holdings in the portfolio, and creates a tax-aware sell and buy list.

And this is not simply in one portfolio. The assessment can be used to cover the different portfolios owned by a household, so if the client happens to have taxable bonds concentrated in the IRA while holding stock ETFs in the taxable portfolio, your recommended buys and sells will be made across all the holdings to create a blended “50” household risk score.

“In the real world, your Roth IRA allocation may be much riskier than your taxable account,” says Evans. “What matters is your overall risk profile compared with your risk tolerance, not what you have in any individual portfolio.”

The software has recently added an alerts system, so advisors can ask Trade Warrior to alert them whenever any asset category has deviated 7%, 10% or 15% from the target allocation. You can be notified if the cash position is too low to make the next required minimum distribution in an IRA account, or when there’s a significant tax-loss harvesting opportunity – and all the triggered alerts, showing which tolerances set by the advisor were breached, are displayed on the home screen.

Trade Warrior also creates and maintains a compliance process that documents when the alignment between client portfolios and risk tolerance was reviewed, when the portfolios were rebalanced and when tax losses were harvested.

Trade Warrior’s cost varies depending on the size of your firm. The base price is $500 a month, and then you add $2.50 per million dollars of AUM per month. “A firm with $100 million under management is going to pay anywhere from $8,000 to $9,000 a year,” says Evans. “If they have $200 million, then the cost will be $13,000 to $14,000 a year.”

Technology allows you to be competitive in the post-DOL environment

Mixing and matching these tools to get full coverage of the DOL requirements will be challenging. But the good news is that the fiduciary regulation is driving software innovation that will save time and provide better justification for your recommendations. Better integration will follow, and as the fiduciary software gains adoptions, fiduciary practices will become more mainstream around the profession.

Meanwhile, there are a couple of software programs that offer a broader integration of features: fee comparisons combined with portfolio-assessment tools along with downside-risk measurements. I’ll look at those in the next installment.

Bob Veres' Inside Information service is the best practice management, marketing, client service resource for financial services professionals. Check out his blog at: www.bobveres.com. Or check out his Insider's Forum Conference (for 2017 in Nashville) at www.insidersforum.com.

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