Your Responsibilities as a Fiduciary

At the University of Colorado in Boulder, foundation board members and staff are currently dealing with an unusual lawsuit which alleges mismanagement of its $2.4 billion portfolio1 for lagging the S&P 500. A wealthy donor, Clarence Herbst, sued in July 2020 after years of agitating against active management and alternative investments.

In the U.S. District Court for the District of New Jersey, an Employee Retirement Income Security Act (ERISA) lawsuit has been filed naming as defendants Barnabas Health2 and various retirement plan committees and individuals alleged to be fiduciaries of the health care system’s 401(k) and 403(b) defined contribution (DC) retirement plans. The complaint states that one indication of the defendants’ failure to prudently monitor the plans’ funds is that the plans have retained several actively managed funds despite the fact that the funds charged “grossly excessive fees compared with comparable or superior alternatives.”

PEOPLE WHO SERVE ON BOARDS AND INVESTMENT COMMITTEES—WHETHER FOR A NONPROFIT, COMPANY OR RETIREMENT PLAN—GENERALLY HAVE GOOD INTENTIONS. HOWEVER, SOMETIMES THEY DON’T HAVE A FULL APPRECIATION FOR THE RESPONSIBILITY THEY WILL SHOULDER WHEN THEY SIGN UP TO SERVE–PARTICULARLY THEIR FIDUCIARY RESPONSIBILITIES.

These are two very different situations, but what they have in common is that their trustees and committee members are considered fiduciaries. The CFA Institute3 defines a fiduciary as a person or entity standing in a special relation of trust and responsibility with respect to other parties. You are a fiduciary if:

  • You are on the board of a nonprofit, foundation, or endowment, even if you are not on the investment or finance committee
  • You are on the board or investment committee for a public company
  • You own or manage a business that has a retirement plan for employees
  • You are a trustee, legal guardian, or executor of an estate

Most people agree to serve on nonprofit boards and their investment committees because they care deeply about the organizations and missions they are serving.  They want to contribute to causes that help people, animals, the environment, etc.  They serve on the boards of public companies or retirement plans because they want to help ensure that the company or plan does well for all shareholders or participants. And while they are almost always well meaning, sometimes they don’t have a full appreciation for the responsibility they will shoulder when they sign up to serve—particularly their fiduciary responsibilities.

When things go awry, as exemplified in the examples above, it is typically not because board members are intentionally mishandling budgets and investments, but because they don’t know any better. In a case in Monterey County California, 16 directors of an AIDS/HIV program were sued4 by the governor and the attorney general for mismanagement of funds. One had lived out of the state for nearly two years caring for an ailing parent and was not  aware of the situation until she was informed of the $2.8 million lawsuit.

What can a board or investment committee do to avoid these worst-case scenarios? Here are several guidelines and best practices that board members and investment committee member should know.

  1. Understand your role in the fiduciary universe.

While fiduciaries share the responsibilities of trust and stewardship, the universe of those who oversee investments includes three major groups.

Investment Stewards (Board and Committee Members, Plan Sponsors, Trustees)

These are typically board or investment committee members who have a legal obligation to oversee the finances and investments of organizations, companies, and funds responsibly. They may engage the assistance of a third party, such as a financial advisor, but they are ultimately responsible for the decisions that are made and the results that are produced. To make prudent decisions they should 1) carefully vet and select qualified third-party advisors 2) know best practices and 3) know governing bodies and rules as described below.

Investment Consultants (Third-Party Advisors)

Third-party consultants can help investment stewards gain the knowledge they need to make prudent decisions. They are bound, like all fiduciaries, to offer recommendations and advice that is in the best interest of clients as well as their shareholders, retirement plan participants and those served by nonprofits. Effective consultants have deep knowledge of regulations and best practices, as well as various asset classes and fund managers. They must have the background, credentials, and training necessary to educate and guide their clients in establishing processes, setting goals and objectives, and developing investment policy statements (IPS).  Typical responsibilities include:

  • IPS development
  • Investment manager research and selection
  • Performance monitoring and reporting
  • Vendor searches and oversight
  • Documentation and meeting minutes

Investments consultants include independent actuarial/benefits consulting firms; subsidiaries of large financial services (or other types of) firms; specialty consulting boutiques; and brokers. Within these types are two broad categories of consultants: non-discretionary advisors, who provide only advice and recommendations to board members, and discretion-ary advisors, who provide advice and have discretion and control over assets.

Investment Managers

According to the SEC, an institutional investment manager5 is “an entity that either invests in, or buys and sells, securities for its own account. For example, banks, insurance companies, and broker/dealers are institutional investment managers. So are corporations and pension funds that manage their own investment portfolios.”

An institutional investment manager is also a natural person or an entity that exercises investment discretion over the account of any other natural person or entity. For example, an investment adviser that manages private accounts, mutual fund assets, or pension plan assets is an institutional investment manager. So is the trust department of a bank.

Investment managers work with investment consultants (if they aren’t filling both roles) as well as investment stewards to implement the decisions made about institutional funds and investments. One of their key responsibilities is evaluating funds and fund managers for inclusion in portfolios. Among the factors they consider are:

  • Risk assessment
  • Process and portfolio characteristics
  • Fees
  • Performance measurement and attribution analysis
  • Fit in the client’s portfolio – initial and ongoing
  • Client’s active risk tolerance (particularly downside)
  • Client’s understanding of the investment strategy
  • Manager’s willingness/ability to provide client service
  1. Know the rules, laws and organizations that govern your investment activities. 

Fiduciary stewards should understand and appreciate the rules regulations that not only govern their investments, but also those who provide advice and investment management.  While it is not necessary to be able to quote law and codes it is important to have a basic understanding, because without this knowledge it would be difficult if not impossible to know if guidelines are being followed or violated.  The governing rules can be quite different depending on what type of organization you serve and the role you play. Below are just a few.

Endowments

UPMIFA (Uniform Prudent Management of Institutional Funds Act)

UPMIFA is an evolution of UMIFA,6 the Uniform Management of Institutional Funds Act—a uniform law which provided rules regarding how much of an endowment a charity could spend, for what purpose, and how the charity should invest the endowment funds. UMIFA was thought to be out of date, particularly as to management, investment, and spending issues so it was updated.

UPMIFA was approved by the National Conference of Commissioners on Uniform State Laws in July 2006 and has been adopted in virtually every state. It focuses on seven factors institutions should consider in the prudent expenditure of both appreciation and income (as opposed to older trust law that allowed only the spending of income).

Trustees

UPIA (The Uniform Prudent Investor Act) 

UPIA is a uniform statute7 that sets out guidelines for trustees to follow when investing private trust assets. It is an update to the previous prudent man standards intended to reflect the changes that have occurred in investment practice since the late 1960s. Specifically, the Uniform Prudent Investor Act reflects a modern portfolio theory (MPT) and total return8 approach to the exercise of fiduciary investment discretion.

The Prudent Man Rule was based on Massachusetts common law written in 1830 and revised in 1959. It stated that a trust fiduciary was required to invest trust assets as a “prudent man” would invest his own assets, thoughtfully considering the needs of the beneficiaries, the need to preserve the estate and need for income.

Retirement Fund Sponsors

ERISA (Employee Retirement Plan Income Security Act of 1974)

ERISA9 protects the interests of employee benefit plan participants and their beneficiaries. It protects retirement savings from mismanagement and abuse and clarifies that those in charge of those savings be held to a high standard – that is, they must act in the best interests of plan participants. It also requires transparency and accountability, ensuring that participants have access to information about their plans. More than half of America’s workers earn health benefits on the job, and ERISA protects those too, as well as other employee benefits.

Administered by the Department of Labor, ERISA requires plan sponsors to provide plan information to participants. It establishes standards of conduct for plan managers and other fiduciaries. It establishes enforcement provisions to ensure that plan funds are protected and that qualifying participants receive their benefits, even if a company goes bankrupt.

Consultants and Advisors

IAA (Investment Advisers Act of 1940)

Administered by the SEC, the Investment Advisers Act10 addresses who is and isn’t an advisor/adviser by applying three criteria: what kind of advice is offered, how the individual is paid for their advice/method of compensation, and whether or not the lion’s share of the advisor’s income is generated by providing investment advice (the primary professional function).

The act stipulates that anyone providing advice or making a recommendation on securities (as opposed to another type of investment) is considered an advisor. Individuals whose advice is merely incidental to their line of business may not be considered an advisor, however. Some financial planners and accountants may be considered advisors while some may not, for example.

Other Governance and Guidance Sources

Depending on what kind of fiduciary you are and the type of organization in which you are involved, there may be dozens of other sources of governance and guidance that apply to your investment processes. Each state has its own statutes regarding risk and diversification, prudence, and ethical standards. There are also many professional associates that provide excellent guidance on diversification and liquidity requirements as well as best practices.

  1. Formalize and adhere to a standard process. 

Establishing and following a process for your plan, company or organization that incorporates best practices will go a long way toward mitigating liabilities and helping you achieve your goals. It should align with your cash flow requirements, investment objectives, and spending rates. At FourThought Institutions we help our clients establish a process and IPS based on the following steps.

Assess committee members’ views, opinions, knowledge, and preferences.

Committee members must be involved in creation and adoption of the IPS. In addition, they must be able to accurately communicate their wishes to investment consultants and managers. It is important to build consensus in the early stages of IPS development. Key questions include:

  • What do you view as the core purpose of the plan, fund, or endowment?
  • What are your objectives, goals, and preferred strategies?
  • To what extent you willing to accept losses?
  • Do you prefer certain management styles, such as active or passive?
  • Do you prefer certain reporting process and procedures?

Determine goals and objectives.

After surveying members and achieving a consensus, specific goals and objectives must be discussed and documented.

Establish and update the IPS.

The IPS is the foundation of success for an investment committee. Determining the investment policies and creating a written statement is one of the most important functions of fiduciaries.

If the trustees can’t develop and convey a clear sense of what the Fund is attempting to achieve and how they expect staff members to go about accomplishing those objectives, then the investment program will be directionless and the trustees will be prone to pursue ineffective approaches that lead to unsatisfactory results.

In “A Primer for Trustees,”11 written by three CFA® charter holders for the CFA Institute’s Research Foundation, the authors note,  “If the trustees can’t develop and convey a clear sense of what the Fund is attempting to achieve and how they expect staff members to go about accomplishing those objectives, then the investment program will be directionless and the trustees and staff will be prone to pursue ineffective approaches that lead to unsatisfactory results.”

The IPS not only provides guardrails, it also becomes the basis of a strategic plan. Its primary elements include:

  • The fund’s mission
  • Investment risk tolerance (i.e., the ability and willingness to bear investment risk)
  • Spending rates
  • Investment goals and objectives
  • Asset allocation and mix
  • Performance benchmarks and evaluation

Establish a long-term strategic allocation with a five to seven-year time horizon.

Based on the IPS an appropriate asset allocation model that aligns with the desired strategy and goals can be established. Investment committees may meet as often as quarterly to review portfolio and performance results—but given this frequency, it can become easy to focus on short-term periods of relative performance versus a benchmark, which can ultimately lead to poor decision making.

By nature, institutions generally have a long-term time horizon, often in perpetuity, which aligns with a longer-term performance evaluation period. Institutions should consider a full market cycle of at least five years.

Implement through consistent process

Consistency is important not only for planning, but also for implementation. Useful tools for consistent implementation and quality control include a matrix of assigned responsibilities, a calendar of fiduciary activities and pre-determined schedule of performance evaluation and risk analysis.

Manager and fund selection processes should also follow a process with established criteria such as duration, credit risk, volatility, and rate of return. In addition, fund managers should be assessed to understand how returns were achieved, what risks were taken and whether the investment style was consistent with the manager’s mandates.  Committee and board members can delegate such tasks to their consultants.

  1. Routinely monitor performance against benchmarks and peers and re-evaluate risk.

Performance evaluations are the most important tool for keeping funds on track and goals in sight. They should be conducted regularly (usually quarterly, at minimum). The sources of investment performance are documented in the IPS.

The use of benchmarks as reference points helps fiduciaries answer the important questions of “How are we doing?” versus the market, peers, and established goals. Benchmarks help support fiduciaries in their obligation to monitor and evaluate performance.

At the manager level, benchmarks serve as standards for measuring the value added by active money managers. At the total portfolio level, benchmarks allow fiduciaries to understand how their investment program is doing relative to the established goals and mission of the organization and to help determine if they’re making good decisions. Selecting appropriate benchmarks is an important fiduciary responsibility—the specific benchmarks are another part of the IPS.

Below, the CFA Institute has defined the most important characteristics of benchmarks.

Characteristics of a Good Benchmark

Questions to Ask Yourself as a Fiduciary Steward

Do You Know?

  • The duties of care, loyalty, and obedience?
  • If appropriate internal controls are in place?
  • If your investment plan is following appropriate laws, rules, and best practices?
  • If your allocation and performance is compared to appropriate benchmarks and peer groups?
  • If the management costs are competitive?

Do You Have?

  • Assigned fiduciary responsibilities?
  • A calendar of fiduciary activities?
  • A pre-determined schedule of risk analysis

Patrick Baumann, CFA®

 

Patrick Baumann is an international finance professional and CFA® charter holder with a background in managing the assets of endowments and large corporate retirement plans. He is the Chief Investment Officer and senior consultant for FourThought Institutions.

FourThought Institutions is owned by FourThought Financial, LLC (FFLLC) is an SEC-registered investment advisor. For information pertaining to FFLLC please contact FourThought Institutions or refer to the SEC’s website,www.adviserinfo.sec.gov. This presentation is provided for informational purposes, not as personal investment advice. This presentation may contain certain forward-looking statements which indicate future possibilities. Any hypothetical example is intended for illustrative purposes only and does not represent an actual client or an actual client’s experience, but rather is meant to provide an example of the process and the methodology. Any reference to a market index is included for illustrative purposes. It should not be assumed that your account performance will correspond directly to any benchmark index. There is no guarantee views and opinions expressed herein will come to pass. Past performance is no guarantee of future results.

Sources:

  1. https://www.institutionalinvestor.com/article/b1nzgfxtb7p4cs/A-University-Endowment-Got-Sued-for-Lagging-the-S-amp-P-500-Now-It-s-Fighting-Back
  2. https://www.plansponsor.com/another-health-care-provider-accused-erisa-breaches/
  3. https://www.cfainstitute.org/
  4. https://californiahealthline.org/morning-breakout/brown-sues-monterey-county-aids-project-over-misuse-of-funds/
  5. https://www.sec.gov/divisions/investment/13ffaq.htm#:~:text=An%20institutional%20investment%20manager%20is,manage%20their%20own%20investment%20portfolios.
  6. https://www.adlercolvin.com/the-law-of-endowments-the-uniform-prudent-management-of-institutional-funds-act-upmifa/
  7. https://www.investopedia.com/terms/m/modernportfoliotheory.asp
  8. https://www.investopedia.com/terms/u/uniform-prudent-investor-act.asp#:~:text=The%20Uniform%20Prudent%20Investor%20Act%20(UPIA)%20is%20a%20statute%20that,would%20invest%20his%20own%20assets.
  9. https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/what-is-erisa
  10. https://www.investopedia.com/terms/i/investadvact.asp
  11. https://www.cfainstitute.org/-/media/documents/book/rf-publication/2011/rf-v2011-n1-1-pdf.ashx

 

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