Investment Advice and Retirement Plans

miller_georgeH.R.2989: 401(k) Fair Disclosure and Pension Security Act of 2009

Chairman George Miller’s latest bill to address issues in the retirement plan marketplace, H.R.2989, has two significant sections for the defined contribution marketplace. The first, “401k Fair Disclosure for Retirement” requires enhanced fee disclosures to plan sponsors and participants. The second, “Prohibition of Conflicted Investment Advice” seeks to reduce conflicts of interest by requiring that advice providers be registered under the Investment Advisers Act of 1940. These two pieces of the bill were previously separate bills, fee disclosure was introduced as H.R.1984 and investment advice was introduced as H.R.1988, but they were merged to create H.R.2989. Because we have already devoted substantial energy and effort to explain and support the fee transparency part of the bill, we believe it is important now to address the investment advice portion in greater detail.

Background on Investment Advice


Rand Report: Investor and Industry Perspectives on Investment Advisers and Broker-Dealers.

The investment advice portion of H.R.2989 is just one part of a larger debate related to competing regulatory structures and standards of care of broker-dealers and investment advisers. The Securities Exchange Act of 1934 (48 Stat. 881) regulates brokers and dealers, and the Investment Advisers Act of 1940 (54 Stat. 847) regulates investment advisers.  Broker-dealers are subject to a standard of care that is built around “arms-length” relationships, “fair-dealing” and the concept of suitability. The primary requirement is that brokers must have an “adequate and reasonable basis” upon which to recommend a transaction to a retail client and this transaction must be suitable to a client’s financial situation, needs and risk tolerance. Broker-dealers also have other requirements, such as the best execution of securities transactions, reporting requirements and significant compliance and oversight rules; however, the fundamental fact is that nowhere in statute or regulation does it state that brokers owe a fiduciary duty to a client. Investment advisers, on the other hand, owe an affirmative fiduciary duty to their clients that requires them to act only in the best interest of the client and to avoid or disclose all direct and indirect conflicts of interest. Historically these different regulatory structures made sense because broker-dealers primarily executed investment transactions whereas investment advisers focused on supplying investment advice. However, over the past 10-15 years the lines of demarcation between broker-dealers and investment advisers have become increasingly murky. The advent of fee-based brokerage accounts that look and function very similarly to advisory accounts and the increasing use of titles such as “investment advisor” or “wealth manager” by brokers has made the distinction harder for consumers to understand (for background on fee-based brokerage accounts please read the Tully Report, the SEC rule, and the subsequent court case overturning the rule). In addition, many “independent” investment adviser representatives are registered representatives of broker-dealers and agents of insurance companies. To make matters worse, investors seem to be oblivious to the distinctions among the titles, regulatory structures and competing standards of care within the industry. For a more in-depth review of the regulatory history and current state of the industry we recommend a complete review of the RAND Report. Though it is long, the report should be required reading for all interested in this matter.

Movement Towards a Unified Regulatory Structure and Standard of Care

Over the past few years there has been a growing consensus that a single regulatory structure for all financial firms and representatives offering investment advice might reduce investor confusion and eliminate regulatory gaps. This debate has been brought to a head by the financial crisis and particularly by major scandals such as Bernard Madoff’s $50 billion fraud. Earlier this year the Treasury Department put forth its recommendations for regulatory reform. The highlights included a Financial Services Oversight Council to protect against systemic risks in the economy, a broader role for the Federal Reserve in policing systemically important firms, registration of hedge funds with the SEC and more particular to the question at hand, a Consumer Financial Protection Agency as well as “a level playing field and higher standards for providers of consumer financial products and services.” On July 10 the Treasury released a proposed “Investor Protection Act of 2009.” The document described the establishment of “a fiduciary duty for brokers, dealers and investment advisers, and harmonization of the regulation of brokers, dealers and investment advisers.” The proposed “harmonized” standard of care included the following wording:

“(T)he Securities and Exchange Commission may promulgate rules to provide, in substance, that the standards of conduct for all brokers, dealers, and investment advisers, in providing investment advice about securities to retail customers or clients (and such other customers or clients as the Commission may by rule provide), shall be to act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”

The description of the standard of care in Treasury’s proposal was deemed by many in the Investment Adviser world as a dilution of the fundamental fiduciary obligations. Critics were quick to point out that the use of the word “fiduciary” was notably absent. Critics were also upset that certain words and phrases in the description of the standard of care (“may”,”in substance” etc.) gave the SEC too much room to deviate from the Advisers Act.

As with most debates there are two camps. Both camps generally agree that a universal standard of care is necessary, but they disagree on the substance of the standard. The fiduciary camp supports extending the fiduciary provisions of the Advisers Act to all investment advice providers and is concerned that any “harmonization” might lead to dilution of the fiduciary protections of the Advisers Act. The other camp has argued for a “new federal fiduciary” or “overarching” standard that reconciles the fiduciary standard for investment advisers with the suitability standard for broker-dealers, but is careful to point out that the new standard should not apply to the non- retail advice portions of broker-dealer businesses. Here is a quick overview of the two groups:

In Support of the “Existing” or “Authentic” Fiduciary Standard*

  • investment_adviser_associationInvestment Adviser Association (IAA), Fund Democracy, Consumer Federation of America, NASAA (read the PDF)

“While we applaud the intent evident in this provision and believe it represents a good starting point, we believe revisions will be needed to unambiguously provide for the extension of the overarching fiduciary duty that investment advisers owe their clients under the Advisers Act to brokers and others who provide investment advice, that this fiduciary duty is explicitly recognized in law, and that the legislation does not in any way undermine the fiduciary duty that already exists under the Advisers Act.”

  • cfp_logoCertified Financial Planner Board of Standards, the Financial Planning Association (FPA) and the National Association of Personal Financial Advisors (NAPFA) (read the PDF):

“Our goal is to have all financial intermediaries who offer broad-based financial advice subjected to the high standards of a fiduciary. We are working with a group of organizations that represent diverse interests and constituencies to support this concept. We all share the view that the highest legal standard—the fiduciary duty—should apply to all who give financial advice to clients, as we laid out in our July 14 letter to Chairman Frank and Ranking Member Bachus.”

  • Committee for a Fiduciary Standard: Fi360, Alpha Wealth Strategies, Evensky & Katz, Garrett Planning Network, Gibson Capital, Matt Hutcheson, Unified Trust Company, Reish & Reicher, R.W. Roge, Rembert Pendleton Jackson, Kate McBride. (read the petition)

“Wall Street needs real reform. The Committee for the Fiduciary Standard calls on Congress to make sure that any new laws or regulations about the fiduciary standard meet the requirements of the authentic fiduciary standard. The core principles of the authentic fiduciary standard are:

• Put the client’s best interest first;
• Act with prudence; that is, with the skill, care, diligence and good judgment of a professional;
• Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;
• Avoid conflicts of interest; and
• Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.”

  • cfa_logoConsumer Federation of America (CFA), Travis Plunkett (read the PDF)

“[T]he words fiduciary duty of care and loyalty that are referenced in the President’s plan should be included in the legislative language itself, so that the fiduciary duty exists in law and not simply through the adoption of SEC rules. … In addition, the SEC should be required, not simply authorized, to adopt the appropriate standards. Finally, Congress should clarify, preferably through the legislation itself but if not through accompanying report language, that: 1) the intent is to ensure no weakening of the fiduciary duty that currently applies to advisers and 2) that a fiduciary duty, once entered into, cannot easily be abandoned; brokers who are covered by a fiduciary duty when giving advice cannot escape that requirement when selling the products to implement that advice.”

  • uspirg_logoU.S. Public Interest Research Group (U.S. PIRG), Edmund Mierzwinski (read the PDF)

“Over the past two decades, in response to competition from both financial planners and discount brokers, full service brokers have transformed their business model into one that is, or at least appears to be, largely advice-driven. They have taken to calling their sales representatives “financial advisers,” offered investment planning services, and marketed their services based on the advice offered. The SEC permitted this transformation without requiring brokers to comply with the Investment Advisers Act provisions designed to govern such conduct. Instead, each time the SEC has had to make a choice between protecting investors and protecting the broker-dealer business model, it has chosen the latter. The President’s plan attempts to reverse that trend, by ensuring that all those who offer advisory services are subject to the appropriate fiduciary standard of care and loyalty and by improving the quality of pre-engagement disclosure investors receive about these obligations.”

“Harmonization” that seeks to make advisers more like brokers has no foundation in investor protection. Second—and following directly from the first principle—the standard that governs the provision of investment advice must be one that explicitly incorporates the fiduciary duty that governs investment advisers’ dealings with their clients. Anything less will fall short of the investor protections currently enjoyed by advisory clients. Section 913(b) of the draft legislation attempts to describe a standard that appears to be “in substance” similar to a fiduciary duty. But it fails to state expressly that brokers and advisers alike must act as fiduciaries. In effect, it would dilute the protections currently provided to advisory clients. A statute that purports to protect investors must not lower standards and weaken protections they have historically enjoyed.”

In Support of a “New Federal Fiduciary”,”Overarching” or “Properly Designed” Standard*

  • sifma_logoSIFMA, the lobbying arm of the broker-dealer industry (Randolph Snook, EVP) (read the PDF)

“Individual investors deserve – and SIFMA strongly supports – a new federal fiduciary standard of care that supersedes and improves upon the existing fiduciary standards, which have been unevenly developed and applied over the years, and which are susceptible to multiple and differing definitions and interpretations under existing federal and state law.”

  • morgan_lewis_logoThomas P. Lemke, Legg Mason and Steven W. Stone, Morgan, Lewis & Bockius (read the PDF)

“Though this standard has not yet been fleshed out fully, it seeks to avoid the use of legalistic labels—such as “fiduciary duty”—which the broker-dealer industry believes contributes to, rather than resolves, investor confusion. Rather, the new standard will be designed to express, in plain English, the fundamental principles of fair dealing that investors should expect from all financial professionals who give investment advice, whether they are financial planners, investment advisers, securities broker-dealers, a banks [sic], insurance agencies, or other types of financial services providers. In this way, the new standard will focus largely on the common standards of conduct shared across those professions in a measured way that also reflects the differing roles they play and obligations they have. Presumably, however, as this standard is defined, it will build on principles found in the existing broker-dealer regulatory scheme.”

  • SEC Commissioner Elisse Walter (read the speech)

“[W]hat a fiduciary duty requires depends on the scope of the engagement. Thus, it will mean one thing for a mere order taker, another thing for someone who provides a one-time financial plan, and yet something else for someone who exercises ongoing investment discretion over an account. What a fiduciary duty requires may also depend, in certain respects, on the sophistication of the investor. What may be appropriate behavior toward large institutional investors, with knowledgeable counsel, may not be appropriate behavior toward retail investors… who are not always going to understand the meaning of disclosures regarding certain conflicts of interest.”

  • Richard Ketchum, Chairman and CEO of the Financial Industry Regulatory Authority (FINRA) (read the source)

“Without suggesting an exclusive list, I would recommend these principles should include the following: Every person who provides financial advice and sells a financial product is tested, qualified and licensed; Advertising for financial products and services is not misleading; Every product marketed to them is appropriate for recommendation to that investor; A full and comprehensive disclosure for the services and products being marketed that address, in plain English, the risks, including the worst-case risks, of the product; and Every person who is in the business of regularly providing financial advice is subject to a federally crafted fiduciary standard.”

* Any omissions to this list were purely unintentional. If you would like to add to this list please contact

BrightScope’s Analysis

In order to understand what is happening in the world of investment advice, historical perspective is required. The growth in the investment advisory business has been the big trend for years in the investment world. Successful brokers are increasingly leaving their broker-dealers and setting up their own investment advisory businesses. The primary reason cited for this shift is the demands of clients who are fed up with Wall Street scandals and the conflicts of interest of their advisers. The broker-dealer industry is under attack from both sides of its retail business: discount brokers stealing its trading clients, and top brokers walking away with its high net worth clients. To stem their losses, broker-dealers have sought to position themselves as advice providers without having to don the cap of a fiduciary adviser. This shift has created great confusion for consumers and in our minds is the primary reason why a uniform standard of care for advice providers is required.

One of the primary arguments against the use of the fiduciary standard has been put forth by Thomas Lemke and Steven Stone, and holds that “legalistic language” confuses investors. To make their case that “legalistic language” confuses investors, Lemke and Stone point to the Rand Report. A close inspection of the Rand Report leads us to believe that Lemke and Stone are confused about the primary cause of investor confusion. The problem is not that investors are aware of regulatory differences but are confused by the term “fiduciary.” Quite to the contrary, investors are simply unaware of regulatory differences and are  bringing their own expectations to the table when dealing with their advisors.  When surveyed, investors responded that they believe their financial services representatives are acting in their best interests (RAND Report, Regulatory and Legal Background, 19). Advisers operating under the Investment Adviser Act of 1940 and who owe a fiduciary duty to their clients meet this expectation, but brokers do not. The confusion is not one of terminology, but rather one of expectations, and brokers are not living up to the expectations of their clients. An investor survey performed by TD Ameritrade and mentioned in the Rand Report resulted in the following:

More than 60 percent of respondents believed that brokers have a fiduciary duty, and 90 percent of respondents believed that investment advisers have a fiduciary duty. The majority of respondents would not seek services from a broker if they knew that brokerage services provided fewer investor protections, that brokers did not have a fiduciary duty, or that brokers were not required to disclose all conflicts of interest. After being presented with the disclosure statement specified by the 2005 rule, 79 percent of respondents reported that they would be less likely to seek financial advice from a brokerage firm.

It appears that investors expect to receive advice from conflict-free advisers. Read in its entirety the Rand Report creates a compelling case for unifying regulation under the affirmative fiduciary obligations of investment advisers, not vice versa. The “confusion” arguments against the fiduciary standard of care fail this basic test of alignment with investor expectations.

There is a more fundamental flaw to Lemke and Stone’s argument. Their preferred approach, or rather the preferred approach of the broker-dealer industry, is to use “plain English.” Presumably, plain English means not using the term “fiduciary.” However, the term “fiduciary” is the term that is most beneficial to investors. There is a very clear legal standard and history dating back over a hundred years that accompanies the term “fiduciary” and that applies to a variety of relationships in a variety of industries; trustee/trustor,  parent/child, lawyer/client etc.  It is commonly accepted that the fiduciary standard is the highest standard of care known to the law and that no other standard can supersede or improve upon it. Because of the duty of prudence owed by fiduciaries, fiduciaries must adopt any practice, understanding or method deemed to be an improvement upon the existing standard. In such a way, the fiduciary duty requires fiduciaries to always elevate themselves to the highest standard of care then attainable. As such there is no need for an “improved” or “enhanced” standard of care.

While BrightScope supports a fiduciary standard of care for all investment advice providers, we recognize that the fiduciary standard of care is not a cure-all for financial regulation. There are certainly elements of investment adviser supervision that must be improved. In the short term, we believe the SEC is on the right track with two of its initiatives aimed at preventing fraud by investment advisers. The first initiative closed the loophole that allowed non-public broker-dealers to use accounting firms not registered with the PCOAB. This change is complete and is effective for audit periods ending after 12/31/2008. The second major initiative is a comprehensive review of Rule 206(4)-2 which regulates the custody practices of advisers and requires investment advisers with legal custody of client assets to maintain those assets with one or more qualified custodians. The SEC has already proposed a rule change: Release No. IA-2876. This is a critical rule change because as we have seen in practice advisory clients with assets not held with an independent custodian have a much higher risk of fraud. While we are still reviewing the comment letters on this proposed rule, at present we believe that investment advisers with “full custody” of advisory client assets should be subject to surprise examinations and required to conduct a SAS 70 Type II report. The SEC should look seriously at taking a bifurcated approach to custody with stricter rules in place for advisers with “full custody” and more lenient rules in cases in which advisers have limited custody solely for the purpose of withdrawing fees. While both cases are cause for concern, the former case is of significantly greater concern and affects a more limited set of advisers making regulation more effective. We also believe the SEC should adopt a non-rebuttable presumption that an investment adviser has custody if any related-person has custody of advisory client assets. In response to the current crisis, investor protections must be strengthened, not weakened. In some cases investment adviser regulation can learn from the regulatory standards used by FINRA to regulate the broker-dealer industry.

Investment Advice and Retirement Plans

The defined contribution marketplace presents an interesting dilemma. The government has created strong incentives for investors of all types — sophisticated and novice — to participate in their workplace retirement plans by offering a generous tax incentive to participate.  Employers often provide an additional incentive by offering matching and profit sharing contributions to participants’ accounts.  Finally most new employees do not have access to defined benefit retirement plans and are skeptical about the presence of Social Security in their retirement years.  This triple encouragement  – a tax reduction, “free money” from employers, primary retirement vehicle – creates an overwhelming incentive for participants to participate in defined contribution plans. Because of the increasing strategic importance of these plans, all threats to the security of defined contribution plan assets must be elevated to the status of serious threats to national security. With this in mind, we find the logic behind the inclusion of the advice portion of the bill very compelling.  The bill points to a Government Accountability Office (GAO) study which revealed that the presence of conflicts in the provision of investment advice has a negative impact on returns in defined contribution and defined benefit plans. BrightScope wrote about this study back in April.  While the study focused on Defined Benefit plans and was careful not to indicate that the results are proof of a causal relationship between conflicts and returns, the case in the defined contribution marketplace can be made clearly:

Given the multiplicity of parties involved in today’s 401(k) plan arena, many opportunities exist for business arrangements to go undisclosed. Problems may occur when pension consultants or other companies providing services to a plan also receive compensation from other service providers. Without disclosing these arrangements, service providers may be steering plan sponsors toward investment products or services that may not be in the best interest of participants.

While the real impact is unknown, the risks are great enough to retirement security that action is required.


It should be the intent of the legislation to align the standard of care of financial representatives with the expectations of investors and to strengthen investor protections. If “harmonization” is to occur it needs to be the harmonization of investor expectations with the standard of care of their advisers, regardless of whether that financial firm was heretofore regulated as a broker-dealer or an investment adviser. That means upgrading all providers of investment advice to the existing fiduciary standard for investment advisers, not lowering the fiduciary protection via a new “federal fiduciary” standard. Nowhere is this case more clearly evident than with retirement plans, where a higher percentage of investors are unsophisticated and lack the freedoms they have in non-retirement accounts. These investors deserve to have access to conflict-free advice from fiduciary advisers.

Plan participants and plan sponsors can benefit greatly from advice received from true fiduciaries who have only the client’s sole interest in mind. BrightScope stands in support of any piece of legislation that strengthens the standard of care owed to plan participants and plan sponsors.