Investment Policy Statements Can Protect Advisers from DOL Scrutiny

Concerned about conflicts of interest among financial advisers to retirement savers, in April 2016 the Department of Labor (DOL) finalized a rulemaking that imposes Employee Retirement Income Security Act (ERISA) fiduciary status on any person who provides “investment advice or recommendations” to retirement savers or retirement plans.

A discussion paper written by Max M. Schanzenbach, from Northwestern University – School of Law, and Robert H. Sitkoff, from Harvard Law School, notes that fiduciary status under ERISA imposes not only a duty of loyalty but also a duty of care. As the DOL acknowledged, a financial adviser to a retirement saver will now be subject to “trust law standards of care” in addition to “undivided loyalty.”

According to the authors, the fiduciary standard of care is governed by the “prudent investor rule,” which is grounded in modern portfolio theory and requires an overall investment strategy having risk and return objectives reasonably suited to the purpose of the investment account. Under the prudent investor rule, no type or kind of investment is categorically permissible or impermissible. Instead, a fiduciary must evaluate the principal’s risk tolerance and investment goals, choose a commensurate level of overall portfolio market risk and expected return, and avoid wasteful diversifiable risk.

Because of the multiplicity of relevant considerations—including the investor’s risk preferences, age and health, family status and obligations, and other asset holdings and sources of income—application of the prudent investor rule is specific to an investor’s particular circumstances, the paper notes. Accordingly, the rule permits a wide variety of investment techniques, including active investment strategies, provided that the result is an overall portfolio with risk and return objectives reasonably suited to the investor. The rule is principles-based rather than prescriptive.

Application of the prudent investor rule to financial advisers to retirement savers creates new litigation risk for those advisers. “In the wake of the DOL rulemaking, therefore, a financial advisory firm acts at its peril if it overlooks the prudent investor rule,” the authors write.

However, they contend that compliance with the rule is feasible with the tools already in use by other fiduciaries, such as bank trust departments, that have long been subject to the prudent investor rule. The centerpiece of bank trust department compliance with the prudent investor rule is the “investment policy statement.” Such a statement sets forth the individualized investment program created to match the account’s purpose and risk tolerance with a diversified portfolio having an appropriate balance of risk and expected return.                                

The authors point out that an investment policy statement will normally specify the account’s risk tolerance” as well as its investment goals and return requirements in light of the particular circumstances of the account. An investment policy statement will also normally specify asset allocation guidelines, and facilitates rebalancing to maintain proper diversification.

Finally, the authors note, an investment policy statement also provides a paper trail in the event of an audit, litigation, or a dispute, and it facilitates selection of an appropriate performance benchmark against which to compare the account’s performance.