Data & Research November 2, 2016

Advisers Raise Concern Over Low-Cost Digital Portfolios

In light of the DOL’s fiduciary rule, advisory firms are increasingly utilizing digital portfolios with low-cost ETFs; however, some advisers are voicing concern over the potential risks associated with these options.
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The finalization of the Department of Labor (DOL)’s Conflict of Interest rule has pushed advisory firms to prioritize risk mitigation and fee reduction more than in previous generations leading to a rise in the use of digital portfolios comprised mostly of low-cost exchange traded funds (ETFs). This is one of the insights raised in the latest survey by global research and consulting firm Cerulli Associates.

The firm also found that risk mitigation is more important to advisers as an objective for the portfolios they create than seeking return.

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Even though investors have long been unsure of how they pay for advice, Cerulli found that they are becoming increasingly more aware of what they pay for products, causing passive and low-cost options to become popular among retail investors. According to Cerulli, retail investors cite fees as the most important factor influencing their choice of ETFs and the second-most important factor affecting their choice of mutual funds.

However, the study also found that leaders at broker/dealer firms are expressing concern that over-allocation to vehicles that simply mirror indexes can laden portfolios with certain risks, such as overexposure to overpriced stocks that make up the bulk of an index.

Moreover, the survey found that 70% of advisers believe that in a volatile market, active managers can offer downside risk through tactical trading.

“Asset managers that can make the case that their products de-risk a portfolio may find a receptive audience with advisers,” says Tom O’Shea, associate director at Cerulli. “Nearly three-quarters of advisers we surveyed agree that active and passive investments complement each other.”

Some advisers say digital portfolios can be “too simplistic” causing clients to question whether their asset managers are working hard for them.

“Advisers should address this concern by offering higher-order financial planning activities such as goals-based planning,” says O’Shea.

The Cerulli report also shed some light on the growing use of low-fee digital advisers commonly referred to as “robo advisers”, which are opening up the market to investors traditionally underserved by the wider financial services industry because of minimum balance requirements.  

“Innovative digital advisers are taking on clients with shockingly low account minimums,” explains O’Shea. “Traditional firms ignore these lower-tier segments at their peril, because as digital advisers gain a toehold with this demographic cohort, they will begin to capture assets from the middle and mass market investors who are building wealth.”

Cerulli also notes that digital advisers may gain more popularity as risk-reducing options in the implementation of the DOL’s Conflict of Interest or “fiduciary rule,” which goes into effect April 2017.

According to Cerulli, “Advisers highly value the flexibility found in rep-as-portfolio-manager (RPM) platforms, but the DOL rule will force broker/dealers to limit their firms’ risk profiles, and as a result, they will seek to limit the discretion they allow advisers to take over client accounts. Distributors will seek to move advisers into home-office-created portfolios or RPM platforms that have strict guardrails. Consequently, there will be a tug of war between advisers who want to maintain their autonomy and sponsors that want to lower their firm’s risk profile.”

These findings are from the U.S. Advisor Portfolio Construction 2016: Responding to Fee Pressure, Regulations, and Passive Investing by Cerulli Associates. 

Compliance November 2, 2016

ESOP Fiduciaries Ordered to Restore Plan Losses

The fiduciaries did not follow terms of the plan document when paying out participants upon plan termination, a federal court found.
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The U.S. Department of Labor (DOL) has secured a judgment against San Francisco-based California Pacific Bank and four individual fiduciaries, requiring them to pay $866,840 in retirement benefits, plus interest, to employees who participated in the company’s stock ownership benefits plan.

After a trial, the U.S. District Court for the Northern District of California found the defendants acted “in blatant disregard of the express terms of the plan document and of their fiduciary duties” under the Employee Retirement Income Security Act (ERISA), according to a DOL news release. The court ordered Richard Chi, the bank’s chairman, president and CEO and his fellow trustees Akila Chen, Kent Chen and William Mo to pay the employees cash, plus interest, into their retirement accounts.

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The court also found that the defendants diverted $81,407 of an account receivable that belonged to the plan to the bank improperly, and wrongfully transferred $69,745 from the plan’s account to the bank. The court ordered the defendants to repay these amounts too, with interest.

According to the lawsuit filed in 2013, an investigation by the DOL’s Employee Benefits Security Administration (EBSA) determined that, after California Pacific Bank terminated its employee stock ownership plan in December 2010, the plan’s fiduciaries were required by the plan document to sell the plan’s bank stock and pay the participants, in cash, into their retirement accounts. The EBSA found the fiduciaries failed to do what the plan required, and did not follow their fiduciary duties to act in the best interest of the participants. Instead of liquidating the bank stock and paying cash into the retirement accounts of the plan’s participants, they divided up the plan’s stock and put stock, rather than cash, into IRAs for plan participants. The bank is not a publicly traded company, making it difficult if not impossible for the plan participants to sell the bank shares they received.

The EBSA also determined that the participants would have received approximately $1.24 million if the plan’s 97,237 shares had been liquidated and distributed in cash at their assessed December 2009 value.

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