The computer-driven advice model

The Pension Protection Act provides a good outline of the major components required Over the past year, I have written extensively on provisions of the 2006 Pension Protection Act. Let’s now focus on components of the PPA’s computer-driven advice model. When Congress debated the various ways to provide investment advice to 401(k) participants, a primary concern was objectivity, particularly when advice was being provided by an adviser affiliated with a service vendor that had its own group of mutual funds. Congress defined this new role as that of a “fiduciary adviser.” The two “eligible investment advice arrangements” under which the fiduciary adviser could provide advice to participants are: fee-neutral advice and computer-driven advice models. A key question The PPA instructed the secretary of Labor to determine whether certain provisions of the computer-driven advice models also should apply to advisers working with individual retirement account rollovers. (IRAs are under the supervision of the Department of the Treasury.) This past July, the Department of Labor conducted hearings on computer-driven advice models, and our organization, Fiduciary360, provided testimony. Although the DOL and, in turn, the industry are free to define the details of how computer-driven advice models should operate, the PPA provides a good outline of the models’ major components. It requires that computer-driven advice models: Apply generally accepted asset allocation and optimization theories. At the July hearings, the DOL asked nearly every presenter whether optimization software could adequately diversify a portfolio across the entire universe of available investment options. The answer, of course, is no. But in my opinion, the DOL staff missed a critical point: ERISA already requires that an investment adviser demonstrate the due diligence process that was followed in selecting each investment option. That requirement alone has the self-selecting effect of limiting the universe to regulated investment options covered by the readily available databases, mutual funds being the prime example. Use relevant information about the participant. Computer-driven advice models are required to optimize more than just the participant’s age and years until retirement. They also must optimize the participant’s risk tolerance and asset class preferences and factor in all the other sources of retirement income available to the participant, such as the retirement benefits of a spouse or partner. That latter discussion, “other sources of retirement income,” is going to significantly increase the amount of time that will have to be spent with each participant, which is appropriate. But it also will increase the cost of providing advice to participants, which may diminish the benefits associated with the PPA. Use objective procedures to provide prudently diversified portfolios. There is likely to be confusion as to whether a computer-driven advice model is intended to be used just in the development of an asset allocation strategy or to be more inclusive and apply to the development of an overall investment strategy (the traditional, four-step investment management process: organize, formalize, implement and monitor). We believe the latter, which also was the consensus of the other presenters at the DOL hearings. Doesn’t favor investments offered by an affiliated party. At the July hearings, I spent most of my time testifying about “fiduciary rules-based technology,” specifically as it applies to the objective evaluation of proprietary investment products. I was able to demonstrate that existing technology objectively can evaluate both in-house and outside funds against the same objective, due diligence criteria. In addition, the PPA permits a participant to request investment advice other than what is suggested by the computer model as long as the request hasn’t been solicited by the fiduciary adviser. And any transaction that is a result of the computer-driven model must occur solely at the direction of the participant. Short and bald Finally, the PPA also requires that before the computer-driven advice model can be used, and on an annual basis thereafter, the model must be certified by an independent “eligible investment expert.” The million-dollar question is whether the audit is intended to be a “factory certification,” with every intermediary using the model covered by the same certification, or whether a new certification will be required anytime a material change has been made to the model, such as changing the investment options. The DOL has yet to define the requirements of the “eligible investment expert,” but you can be certain that two of the requirements will be that the expert be short and bald. Donald B. Trone is president of the Center for Fiduciary Studies and chief executive of Fiduciary 360 LP, both in Sewickley, Pa.