fiduciary

By Christopher B. Tobe, CFA, CAIA

The CFA Institute Pension Trustee Code of Conduct (Code) sets the standard for ethical behavior for a pension plan’s governing body. [i] It is a global standard that applies to both defined benefit (DB) and defined contribution (DC)plans, but I believe is consistent with ERISA fiduciary standards for 401(k) plans. The Code has 10 fundamental principles of ethical best practices. I am going to focus on 5 of them, the areas where we see many plans falling short of the standards.

Principle # 2. Act with prudence and reasonable care.
The point regarding seeking appropriate levels of diversification[ii] is typically followed with most larger plans; but, we do see a number of mid-size and smaller plans taking single entity credit and liquidity risk in annuities and other insurance products. [iii] A particular non-diversified insurance product, lifetime income, is trying to break into even the largest plans, but with little success. [iv]

Another point is that service providers and consultants be independent and free of conflicts of interest. [v] [vi] Again, most larger plans hire independent providers, but we do see a number of mid-size and smaller plans hire dually registered consultants who not only are registered investment providers, but are also registered as brokers or insurance agents, with the ability to get a commission. [vii]

Principle #3. Act with skill, competence, and diligence.
Ignorance of a situation or an improper course of action on matters for which the trustee is responsible or should at least be aware is a violation of this code. “Trustee” in this case refers to each individual on the 401(k) committee plus the plan as a whole. We have seen many 401(k) committee members lacking awareness of the investment details in options of the plan.

Specifically, this principle points out the need ror awareness of how investments and securities are traded, their liquidity, and any other risks. Certain types of investments, such as hedge funds, private equity, or more sophisticated derivative instruments, necessitate more thorough investigation and understanding than do fundamental investments, such as straightforward and transparent equity, fixed-income, or mutual fund products. [viii]

With investments that have non-SEC regulated securities like illiquid contract-based products like crypto, [ix] private equity,[x] annuities and other insurance products, [xi] many times the 401(k) committees are not aware of the risks and hidden fees and have not thoroughly investigated them on such matters, especially those buried in target date funds and in brokerage windows.

Principle #5. Abide by all applicable laws
Generally, trustees are not expected to master the nuances of technical, complex law or become experts in compliance with pension regulation. Effective trustees …consult with professional advisers retained by the plan to provide technical expertise on applicable law and regulation. [xii]

Principle #3 suggests that assets that are not straightforward and transparent securities, such as crypto, private equity and annuities/insurance products contracts, require additional legal scrutiny. I would assume that no crypto product would pass a good fiduciary law audit. I would claim that it would be the fiduciary duty of the plan going into any private equity or annuity contract (separate account or general account) – to have a side letter in which the manager/or insurance company agrees to take.

1. ERISA Fiduciary duty

2 Provide liquidity if the investment experiences difficulty. With insurance products, this can be done with a downgrade clause, i.e., “in the event that the insurance company’s debt is downgraded below investment grade by any major rating agency, the plan will be returned its contract value in cash within 30 days.”

3. “Most Favored Nation Clause, guaranteeing that the manager /insurance company does not provide a lower fee or higher rate to any other plans

Ownership of underlying securities is key to a plan’s risk exposure, especially liquidity risk, and when complex instruments are involved, it is the duty of the plan committee to get competent legal advice on these investment contracts.

Principle #7. Take actions that are consistent with policies
Effective trustees develop and implement comprehensive written investment policies that guide the investment decisions of the plan (the “policies”). Most of the largest plans have Investment Policy Statements (IPS). The Code expects any plan to have them.

I believe any plan without an IPS is in fiduciary breach. I believe many conflicted consultants, as discussed in Principle #2, recommend that plans do not draft an IPS since it would expose their own conflicts. Most of the riskier assets in Principles #3 and #5, like crypto, private equity and annuities, would not be allowed under a well written IPS due to the excessive risks and hidden fees involved.

Trustees should … draft written policies that include a discussion of risk tolerances, return objectives, liquidityrequirements, liabilities, tax considerations, and any legal, regulatory, or other unique circumstances. Review and approve the plan’s investment policiesas necessary, but at least annually, to ensure that the policies remain current. [xiii] Some plans may have an Investment Policy Statement (IPS), but do not regularly review it or apply it rigorously to their investments.

Select investment options within the context of the stated mandates or strategies and appropriate asset allocation. Establish policy frameworks within which to allocate risk for both asset allocation policy risk and active riskas well as frameworks within which to monitor performance of the asset allocation policies and the risk of the overall pension plan. [xiv]

While asset allocation is a major component of DB plans – US DC plans now have over 50% of their assets in asset allocated investments, primarily target date funds.[xv] In most plans, the target date funds are the Qualified Default Investment Alternative (QDIA), which makes it essential that each target date sleave be addressed in the Investment Policy Statement.

Principle #10. Communicate with participants in a transparent manner.
While the DOL forces some fee disclosure on each plan investment, it is not complete with non-securities like crypto, private equity and annuities as standalone options[xvi], in brokerage windows or inside target date funds. [xvii]

Revenue sharing is a shady non-transparent way some plans make their own participants pay for administrative costs; it does not hold up under these CFA standards in my opinion. [xviii]

Given the similarity between ERISA’s fiduciary requirements and the CFA Institute Pension Trustee Code of Conduct, 401(k) plan sponsors could greatly mitigate their litigation risk by looking at the Code. Furthermore, it is just the prudent and the right thing to do as a fiduciary.

Chris Tobe, CFA, CAIA is the Chief Investment Officer with Hackett Robertson Tobe (HRT) a minority owned SEC registered investment advisor and recently was awarded the CFA certificate in ESG investing. At HRT Tobe is leading up the institutional investment consulting practice for both DB and DC Pension plans. He also does legal expert work on pension investment cases.

Past industry experience includes consulting stints at New England Pension Consultants (NEPC) and Fund Evaluation Group. Tobe served on investment committee of the Delta Tau Delta Foundation for over 20 years served as a Trustee and on the Investment Committee for the $13 billion Kentucky Retirement Systems from 2008-12. Chris has published articles on pension investing in the Financial Analysts Journal, Journal of Investment Consulting and Plan Sponsor Magazine. Chris has been quoted in numerous publications including Forbes, Bloomberg, Reuters, Pensions & Investments and the Wall Street Journal.

Chris earned an MBA in Finance and Accounting from Indiana University Bloomington and his undergraduate degree in Economics from Tulane University. He has the taught the MBA investment course at the University of Louisville and has served as President of the CFA Society of Louisville. As a public pension trustee in, he completed both the Program for Advanced Trustee Studies at Harvard Law School and the Fiduciary College at Stanford University.

[i] http://www.cfainstitute.org/-/media/documents/code/other-codes-standards/pension-trustee-code-of-conduct-2019.pdf

[ii] http://www.cfainstitute.org/-/media/documents/code/other-codes-standards/pension-trustee-code-of-conduct-2019.pdf

[iii] https://commonsense401kproject.com/2022/05/11/annuities-are-a-fiduciary-breach/ and

Stable Value: The Good, the Bad and the Ugly-Avoiding Litigation

[iv] https://commonsense401kproject.com/2022/02/10/401k-lifetime-income-a-fiduciary-minefield/

[v] http://www.cfainstitute.org/-/media/documents/code/other-codes-standards/pension-trustee-code-of-conduct-2019.pdf

[vi] https://commonsense401kproject.com/2022/07/24/401k-background-checks/

[vii] https://commonsense401kproject.com/2022/03/09/conflicted-401k-consultants-should-plan-sponsors-fire-them-sue-them-or-both/

[viii] http://www.cfainstitute.org/-/media/documents/code/other-codes-standards/pension-trustee-code-of-conduct-2019.pdf

[ix] https://commonsense401kproject.com/2022/06/18/brokerage-windows-exposed-by-crypto/

[x] https://commonsense401kproject.com/2022/02/15/private-equity-in-401k-plans-a-ticking-time-bomb/

[xi] https://commonsense401kproject.com/2022/05/11/annuities-are-a-fiduciary-breach/ and

Stable Value: The Good, the Bad and the Ugly-Avoiding Litigation

[xii] http://www.cfainstitute.org/-/media/documents/code/other-codes-standards/pension-trustee-code-of-conduct-2019.pdf

[xiii] http://www.cfainstitute.org/-/media/documents/code/other-codes-standards/pension-trustee-code-of-conduct-2019.pdf

[xiv] http://www.cfainstitute.org/-/media/documents/code/other-codes-standards/pension-trustee-code-of-conduct-2019.pdf

[xv] https://commonsense401kproject.com/2022/04/30/problems-with-target-date-funds/

[xvi] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2167341

[xvii] https://commonsense401kproject.com/2022/06/07/toxic-target-date-case-study-of-the-worst-of-the-worst/

[xviii] https://commonsense401kproject.com/2022/10/03/record-keeping-costs-and-the-war-against-transparency/

Republican Attorney Generals across the US have declared that ESG investing is a fiduciary breach because it underperforms typical historic investments, even though they offer no proof. While there can be bad ESG funds with poor performance, high fees and low transparency, that generally has little to do with the ESG part. There have been over 2000 studies on the investment performance of ESG funds, with over 50% showing that ESG has a positive performance effect and 30% showing neutral results. Only 10% of the studies support the attorneys generals’ claim.[i]

While all the factors Environment (E), Social Responsibility (S), and Governance (G) had positive factors on performance, G was the highest at over 60%. A good example of ESG dumping losers is when S&P ESG index dumped Tesla from its index May 2022 when its price was over $317 a share and, by year end 2022, was down to 65% to $112 a share. S&P cited governance related codes of business conduct, lack of transparent reporting on breaches, and the occurrence of corruption and bribery cases and anti-competitive practices as bases for its decision. S&P also cited Tesla’s handling of the NHTSA investigation following multiple deaths and injuries were linked to its autopilot vehicles. [ii] The dominance of single board member, as is the case with Tesla, is considered a substantial weakness in governance,

Governance has focused on corporate governance of public regulated securities. The Council of Institutional Investors in the US has developed an extensive and effective framework for dealing with governance issues in public securities. [iii] The CFA institute has developed an ESG certificate and curriculum, including governance, whose factors highlight overall transparency, accountability and financial integrity, as well boards independence and expertise [iv] There needs to be more upstream applications of governance in investments, first to money managers, consultants, and to the boards of retirement plans and other asset owners

As we have found out with Crypto, the structure of real asset matters. The best structure is to directly own a regulated liquid security that is transparent in your own independent custodial account. This structure allows institutions, such as CII, to have the ability to control and monitor their own individual assets and have complete transparency of the management including fees and commissions associated with trades. Another good structure is owning a regulated liquid security within a SEC registered mutual fund. Collective investment trusts (CIT’s) can be a good structure or a bad structure.[v]

Like crypto, many the most vocal ESG large institutional investors have a blind spot for gof investment structure. Private equity and hedge funds have an extreme lack of transparency and liquidity, as evidenced by the fact that it has been shown that most investors have no idea of how much they pay in fees and expenses and they even lie about their ESG attributes.

New York State and New York City claim to have strong ESG policies. Yet they invest in have private quity firms with horrible ESG records.[vi] Ownership via a contract has few of the protections that a registered security. M of such firms any are domiciled in the Cayman Islands, which seems to be for the benefit of the managers.[vii] Many of these contracts absolve the manager of fiduciary duty and push the risk onto the asset owner.

The majority of 401(k) plan investment options are in transparent SEC registered mutual funds. However, there are significant retirement assets that are not owned by participants directly, but via non-transparent and high fee annuity contracts. These annuity contracts absolve the insurance company of fiduciary duty and push the risk onto the participants, who then have to sue the plan sponsor if they feel they are wronged. I believe that a plan sponsor who puts participants in non-transparent annuity contracts as breaching their fiduciary duty. [viii]

Regulation does matter. For US based asset owners, we have seen the collapse of totally unregulated investments like Crypto. We have private equity and hedge funds that are lightly regulated by the SEC . Federal regulation matters. Annuities and insurance products can cherry pick the weakest state regulator among the fifty states. CIT providers could use the Federal OCC, but mostly choose to use the weakest state bank regulator they can find.

ESG ratings of corporate governance look at regulatory violations. [ix] Violations such as EPA fines for pollution and labor violations, are looked at by ESG analysts. However, many retirement plan and asset owners seem oblivious to continuous violations from asset managers like Wells Fargo and others for violations that include fee gauging and fiduciary breaches. [x]

Good governance is great for investors and should be encouraged. I think these governance principles are consistent with one’s fiduciary duties and need to be expanded. Fiduciaries should follow solid governance by buying real stocks and bonds they can own, instead of fake assets like crypto and/or vague contracts for firms domiciled in the Caymans or regulated by the state of Iowa. Fiduciaries using common sense governance principles should avoid companies that have been fined for fiduciary breaches by the government.

Chris Tobe, CFA, CAIA, was recently awarded the CFA Institute Certificate for ESG investing. He is Chief Investment Officer for the Hackett Group, where he helps manage an ESG Racial Justice Impact Fund.

[i] https://www.tandfonline.com/doi/full/10.1080/20430795.2015.1118917

[ii] https://www.indexologyblog.com/2022/05/17/the-rebalancing-act-of-the-sp-500-esg-index/

[iii] https://www.cii.org/

[iv] https://www.cfainstitute.org/en/programs/esg-investing/

[v] https://commonsense401kproject.com/2022/02/22/cits-collective-investment-trusts-in-401k-the-good-and-the-bad/

[vi] https://www.levernews.com/the-private-equity-black-box-pours-new-york-pensions-touting-divestment-into-fossil-fuels/

[vii] https://commonsense401kproject.com/2022/02/15/private-equity-in-401k-plans-a-ticking-time-bomb/

[viii] https://commonsense401kproject.com/2022/05/11/annuities-are-a-fiduciary-breach/

[ix] https://violationtracker.goodjobsfirst.org/

[x] https://commonsense401kproject.com/2022/07/24/401k-background-checks/