IPSs Are a Good Defensive Move

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

A discussion paper written by Max Schanzenbach, of Northwestern University Pritzker School of Law, and Robert Sitkoff, of 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.” The authors say this should be included in plan investment policy statements (IPSs).

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, other asset holdings and sources of income—application of the prudent investor rule is specific to the 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 suited to the individual.

Application of the prudent investor rule to retirement savers’ financial advisers creates new litigation risk for those professionals. “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.