Some think that broker-dealers, RIAs and their advisors must only recommend the lowest-cost investments. Not so, argues noted ERISA attorney Fred Reish.
In his most recent (78, but who’s counting?) blog post on the subject of the Labor Department’s fiduciary regulation (which he reminds readers has been in effect since June of last year), Reish cites the DOL’s stated position:
“Consistent with the Department’s prior interpretations of this standard [the reasonable compensation standard], the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.” (81 Fed. Reg. 21002, at page 21030 (April 8, 2016))
Contrary to what one might conclude from the rash of excessive fee litigation, the position of the Labor Department (and several courts) is that an advisor’s fiduciary responsibility is to recommend investments with reasonable expenses, Reish notes – “or, in a more specific context, to recommend mutual funds with expense ratios within the range of reasonableness for the particular plan and the type of fund.”
Reish goes on to note that for advisors with broker-dealers, the expense ratio of mutual funds typically includes a cost component and a compensation component (that is, compensation for the advisor), and that in order to assess the reasonableness, you first have to differentiate the cost of the mutual fund versus that of the advisor’s compensation.
Reish explains that once the “true cost” is determined, that should be used as the expense ratio of the mutual fund for purpose of the fiduciary analysis of whether the cost of the investment is reasonable.
The second step in the fiduciary analysis of cost is the determination of whether or not the appropriate share class is being recommended (including, Reish notes as an example, whether waivers are available). “Generally speaking, the lowest-cost available share class should be recommended,” he says, going on to caution that here he is referring to the lowest “net cost” share class. “In other words, the advisor’s compensation (for example, the 12b-1 fee) should be deducted to determine the true cost and then should be compared to the net cost of the other share classes of the same mutual fund.”
Once the investment’s cost and the appropriate share class have been determined, Reish notes, that information should be compared to similar data for other mutual funds in the same investment category – bearing in mind that the requirement is not that the lowest-cost investment be recommended, but that the cost be reasonable relative to the value provided. “On a practical level, that means that there is a range of reasonableness for a given type of investment,” he writes. “The risk is in recommending an investment that is clearly more expensive than what is typically charged for that type of investment.”
Additionally, as fiduciaries for this purpose, the process used for the selection of investments and the determination of the reasonableness of cost should produce documentation that can be retained and retrieved, Reish notes.
