Bogleheads® on Investing Podcast Episode 041 – James Watkins, lll, JD, host Rick Ferri (audio only)

00:00:00.000 | [MUSIC PLAYING]

00:00:10.320 | Welcome everyone to the 41st episode of Bogleheads on Investing.

00:00:15.120 | Today our special guest is James W. Watkins III.

00:00:19.000 | Mr. Watkins is an attorney who specializes in fiduciary law.

00:00:23.200 | He's the owner of Watkins Law Firm and the founder and CEO of InvestSense, an investment

00:00:29.240 | education company.

00:00:30.520 | [MUSIC PLAYING]

00:00:39.080 | Hi everyone.

00:00:39.760 | My name is Rick Ferry, and I'm the host of Bogleheads on Investing.

00:00:43.200 | This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial

00:00:48.800 | Literacy, a 501(c)(3) nonprofit organization that can be found at boglecenter.net.

00:00:58.140 | Your tax-deductible contributions are greatly appreciated.

00:01:01.800 | Today our special guest is James W. Watkins III.

00:01:06.400 | Mr. Watkins has been practicing law for over 40 years.

00:01:10.400 | His law firm is the Watkins Law Firm.

00:01:13.800 | Prior to starting his firm, he has served as a compliance officer with several national

00:01:19.000 | brokerage firms and as the director of financial planning for the advisor industry of an international

00:01:24.420 | insurance corporation.

00:01:25.920 | He has extensive experience in the areas of forensic investment analysis, financial planning,

00:01:31.520 | asset protection, wealth management, and preservation, and particularly fiduciary law and pension

00:01:37.920 | consulting.

00:01:39.080 | He publishes two blogs, Common Sense, InvestSense, and The Prudent Investment Fiduciary Rules.

00:01:46.640 | He's also published the 401(k), 403(b) investment manual.

00:01:50.400 | I'm looking forward to my conversation with Jim today because of his deep knowledge about

00:01:54.760 | fiduciary law, but not just for people in the investment industry.

00:02:00.520 | Fiduciary duty for perhaps you who may be a trustee over a family trust or the beneficiary

00:02:08.120 | of a trust.

00:02:09.120 | I'll also be talking about nonprofit organization fiduciaries and pension fund fiduciaries and

00:02:15.440 | of course investment advisor fiduciaries.

00:02:18.680 | So with no further ado, let me introduce James W. Watkins III.

00:02:25.200 | Welcome to the podcast, Jim.

00:02:26.200 | Thank you for inviting me, Rick.

00:02:28.080 | I have many questions today and I know that there's a lot of misunderstanding about who

00:02:35.640 | is a fiduciary, what fiduciary means, who is not a fiduciary.

00:02:41.960 | I've always been confused by a lot of these things.

00:02:44.960 | But before we get into that, can you tell us a little bit about yourself?

00:02:48.640 | How did you get into this business?

00:02:50.980 | In 1994, for the first time, the SEC required broker-dealers to regulate and oversee the

00:02:58.720 | trading activity of investment advisors.

00:03:01.360 | It's a relatively new area.

00:03:03.520 | There weren't a lot of people who knew those laws.

00:03:07.600 | I happen to be one, so I went to work for one of the largest independent broker-dealers.

00:03:13.720 | And from there, I just gradually grew into the fiduciary duties, the fiduciary law, because

00:03:20.560 | I am an attorney.

00:03:21.920 | I have served as a compliance director both for broker-dealers and registered investment

00:03:29.560 | advisors.

00:03:31.240 | What I do right now is counseling services for pension plans, also provide advice to

00:03:39.000 | high-net-worth individuals, and I provide advice and counseling to trusts, trustees,

00:03:45.840 | and beneficiaries.

00:03:46.840 | I also do some work as an expert witness in 401(k) litigation cases.

00:03:52.720 | And we'll get into some of those in a minute, because there is at least one important case

00:03:57.880 | in front of the Supreme Court right now, which could change the way 401(k) trustees select

00:04:04.320 | investment options, correct?

00:04:06.800 | Correct.

00:04:07.800 | What I wanted to do today was to look at all of the different ways a person can fall under

00:04:16.920 | a fiduciary duty.

00:04:19.560 | And it's not just investment advisors or trustees of pension funds.

00:04:24.880 | A lot of families have set up accounts where there are irrevocable trusts and the trustees

00:04:33.520 | who are overseeing those accounts, usually the parents or the grandparents, have a fiduciary

00:04:41.280 | duty to those assets because they're not managing their own assets anymore.

00:04:47.680 | Those assets are actually in an irrevocable trust.

00:04:51.520 | So to start out today, let's start out with something as simple as that.

00:04:56.560 | Can you talk about family trusts, individual irrevocable trusts, and things that we are

00:05:03.960 | all maybe subject to at some point in our lives with our own family?

00:05:08.600 | Well, there are two main ways that someone becomes a fiduciary.

00:05:14.000 | One is by law, because a statute or regulation imposes the duty on that person.

00:05:21.280 | The second way is by contract.

00:05:24.800 | But when you talk about a trust, especially with a family, the assumption of a fiduciary

00:05:30.880 | duty is by law, because if you're serving as a trustee, whether it be of a nonprofit

00:05:38.320 | or just a family, like you said, irrevocable trust, it's less formal.

00:05:44.000 | So whoever the family agrees will serve as the fiduciary serves as the fiduciary.

00:05:52.200 | The duties of a fiduciary come from the third restatement of trust, and the two main duties

00:05:58.880 | of a fiduciary are the duty of prudence, and then there's a duty of loyalty.

00:06:05.900 | The duty of prudence requires that anyone serving in a fiduciary capacity has to manage

00:06:13.920 | the assets that they're managing with the care, skill, and prudence of what they call

00:06:20.760 | the prudent man standard.

00:06:23.360 | The duty of loyalty requires that the fiduciary manage the assets with an eye solely to the

00:06:31.760 | benefit of the beneficiaries.

00:06:34.600 | So the fiduciary can't put their interest ahead of the beneficiaries of the trust itself.

00:06:42.560 | That said, even in a family situation, even though it's less formal, that person, that

00:06:49.440 | trustee of that trust still has the same duties.

00:06:53.160 | It doesn't matter how you become a fiduciary, the duties are going to be the same.

00:06:58.360 | Okay, so let me just circle back a little bit to irrevocable trust because it does affect

00:07:03.720 | a lot of people.

00:07:04.720 | Can you give us some examples of where a fiduciary who's managing an irrevocable trust might

00:07:09.880 | put their own circumstances ahead of the beneficiaries?

00:07:16.320 | The prime example of that would be a situation where if the individual, the person that serves

00:07:24.140 | as a fiduciary, is a professional investment advisor, and by that, that means not only

00:07:32.540 | a registered investment advisor, it could be a stockbroker.

00:07:37.800 | And in that situation, if that person does work in the investment industry, it's possible

00:07:44.640 | that they could recommend products that are going to benefit them financially more than

00:07:51.280 | they may benefit the trust itself and the beneficiaries.

00:07:55.680 | Well, how does that reconcile with trust companies who are the trustees over these irrevocable

00:08:04.560 | family trusts, and yet they invest in their own mutual funds or they hire themselves to

00:08:13.040 | manage the investment portfolio and never really monitor the performance?

00:08:20.280 | How does that all reconcile?

00:08:22.680 | You as the beneficiary of the irrevocable trust still have a duty to monitor whoever

00:08:29.000 | is managing the trust.

00:08:31.920 | From the trust company standpoint, they still have a responsibility.

00:08:37.520 | Remember, I said that if you're a fiduciary, you have the same responsibilities, whether

00:08:44.840 | you're a professional trust company, whether you're a family member, that is the name fiduciary.

00:08:51.380 | So the responsibilities are the same.

00:08:55.020 | So the trust company, you mentioned proprietary funds.

00:08:58.280 | If a trust company does offer or a bank commercial trust division, if the company offers proprietary

00:09:10.640 | investments, it still has a duty as a fiduciary to make sure that the use of those funds,

00:09:18.440 | the selection of those funds is prudent.

00:09:21.160 | Again, the duty and loyalty of a fiduciary requires that they put the interests of the

00:09:29.080 | beneficiaries of the trust first, first and foremost.

00:09:33.540 | There may be a residual benefit to them, but the primary benefit has to be to the beneficiaries.

00:09:43.520 | So I've met with several people over my years who were the beneficiaries of these trusts,

00:09:49.040 | and the grantor had passed.

00:09:52.360 | And a professional trustee was named who also was working at a institution that had proprietary

00:10:03.480 | products and also fairly costly, active money management strategies.

00:10:11.520 | And it never did I ever see the trustee say, "Our company is not doing a good job managing

00:10:20.520 | this money," even though the fees were considerably higher than what you could get someplace else.

00:10:26.720 | And it was beholden upon the beneficiaries to petition in some way to have this trustee

00:10:37.840 | fired and taken the money away.

00:10:42.140 | Explain all that to me, because it really is difficult for me to get my head around

00:10:46.480 | how all this works.

00:10:48.080 | Well, as an attorney, I do that a lot.

00:10:52.880 | I'm quite often called in to analyze the portfolio that's been produced for the beneficiaries.

00:11:03.200 | And I believe the simplest way to evaluate the prudence of investments, both the portfolio

00:11:09.880 | as a whole or individual, is by simply doing a cost-benefit analysis.

00:11:16.560 | I compare the incremental costs of the investments, each individual investment, to the incremental

00:11:23.080 | return.

00:11:24.880 | I use basically two tests, and these are the two tests that I tell fiduciaries, especially

00:11:31.760 | family members.

00:11:32.760 | They quite often, they'll ask me, "How do I decide what to put in this trust?"

00:11:39.680 | And I tell them, "Compare two investments, typically an actively managed investment to

00:11:45.240 | an index fund."

00:11:46.720 | They're two basic questions.

00:11:49.160 | The first question is, "Is the actively managed fund outperforming the index fund?"

00:11:55.880 | If it is, fine, we'll move to the second question.

00:11:59.360 | If it isn't, then you're losing money.

00:12:02.320 | So that actively managed investment, you should get rid of it.

00:12:07.560 | If the investment is producing a positive incremental return, then the question is,

00:12:15.680 | "Do the incremental costs exceed that incremental return?"

00:12:22.240 | And if the incremental costs are greater, you're basically losing money.

00:12:27.520 | So at that point, based upon what I find, I'll tell a family, "We need to remove this

00:12:35.520 | trustee."

00:12:36.600 | The process itself is very simple.

00:12:39.400 | The court, you go to the courts.

00:12:42.120 | In some states, it's the probate court.

00:12:44.960 | In other states, it may be the superior court.

00:12:48.400 | But basically, you just have, you file a petition.

00:12:52.240 | You have the beneficiaries of the trust say, "We want to remove this person."

00:12:57.840 | And even if, let's say that the trust was created under a will, it's very hard typically

00:13:04.840 | to change, well, the courts don't want to change someone's last request.

00:13:10.160 | But in a situation of a trust, the courts recognize that it's more important to carry

00:13:16.240 | out the decedent's last wishes.

00:13:20.880 | So it's basically very easy.

00:13:22.880 | You go to the court.

00:13:24.000 | If all the beneficiaries agree, they want this person removed for whatever reason.

00:13:29.920 | Doesn't matter if they just don't like him.

00:13:32.840 | It doesn't matter if they say, "Well, the investments aren't doing well."

00:13:37.960 | If all the beneficiaries agree, the court will remove that trustee.

00:13:42.440 | But at the same time, you have to inform the court who the successor trustee will be.

00:13:50.560 | Because they're not just going to leave a trust with nobody managing it.

00:13:55.520 | So if they're going to remove this one individual, be it a professional fiduciary or family member,

00:14:02.720 | they want to know going into that who's going to be taken over.

00:14:07.520 | What does the trust company at this point say?

00:14:09.760 | I mean, you know, they're going to be taken off this trust potentially.

00:14:12.480 | Are they there in the courtroom as well?

00:14:15.360 | They're in the courtroom as well, and that's a great question.

00:14:18.680 | One of the things that has always concerned me is that quite typically, corporate trustees

00:14:25.040 | want you to sign a document.

00:14:27.720 | So let's say that family comes to me and says, "We want to get rid of this trustee."

00:14:34.040 | And let's say it's a professional trustee.

00:14:37.560 | They can fight it if they want to.

00:14:39.520 | But just like I said, in most cases, the court says, "No.

00:14:43.120 | If all the beneficiaries want you gone, you're gone."

00:14:47.040 | Like I said, they know that going into court, the court's going to grant their request.

00:14:52.720 | And it's overreaching.

00:14:54.380 | It's improper for a fiduciary to basically ask the beneficiaries to grant them immunity

00:15:00.660 | for anything they did.

00:15:02.600 | But they will try it unless you have an attorney that tells them, "We're not doing that.

00:15:07.400 | That's improper.

00:15:08.400 | That's unethical."

00:15:09.400 | Yeah, it's interesting.

00:15:10.760 | How often do you see this?

00:15:12.520 | How many cases do you get involved with where a professional trustee, I'm talking big

00:15:16.980 | banks, big trust companies, are fired because of imprudent investing?

00:15:23.720 | You see it more than you'd think.

00:15:25.960 | When my father passed away, he left a sizable trust, left a commercial trustee, because

00:15:32.400 | one thing is a lot of estate planning attorneys and attorneys that just handle these kind

00:15:37.960 | of things, they usually have associations or relationships with banks, trust companies.

00:15:45.240 | So it's a you wash my back, I'll wash yours.

00:15:48.560 | In my case with my father, all the kids got together and I got a power of attorney from

00:15:54.240 | my mother and they didn't fight it.

00:15:58.060 | Unless you can show a really, really strong reason, the courts don't want to force beneficiaries

00:16:07.720 | to work with people they don't trust.

00:16:10.940 | Because the most important element of any fiduciary relationship is trust.

00:16:17.040 | What happens if you have three children and two of them want to leave the trustee and

00:16:20.120 | one of them does not?

00:16:21.800 | How complicated does that become?

00:16:23.600 | Another great question.

00:16:25.960 | That doesn't happen all that often, because usually the reason they want to get rid of

00:16:30.280 | a professional trustee is poor performance.

00:16:34.400 | In the situation where it does exist, if I'm involved, I meet with all the beneficiaries

00:16:41.900 | together and we try to clear the air.

00:16:44.820 | I want to find out why the one family member that does not want to remove the trustee,

00:16:50.660 | why is it?

00:16:52.220 | But usually in those situations, and the more beneficiaries there are, sometimes it's the

00:16:59.420 | harder to get everybody to agree.

00:17:02.740 | If everybody doesn't agree, then you still go to court and you just be honest with the

00:17:08.880 | judge and you say, "Your Honor, you can see from the petition, all but one or two of the

00:17:15.120 | family members want the trustee removed."

00:17:18.920 | Typically, these kind of hearings about removal of a trustee are usually in probate court.

00:17:25.120 | Probate court is less formal than other courts.

00:17:29.020 | In most cases, the judge will just ask the beneficiaries that do not want to remove the

00:17:34.300 | trustee, why they don't want to remove the trustee, and he has an informal discussion

00:17:39.860 | with them there.

00:17:42.280 | At the end of the day, he typically removes the trustee anyway, since the majority of

00:17:47.860 | the beneficiaries, that's their wish.

00:17:51.280 | Great information, Jim.

00:17:52.280 | I just had no idea how it all worked, and I have had so many situations with clients

00:17:56.420 | who got into this problem where their money was not being well managed by a professional

00:18:02.580 | trustee and they did not know what to do about it, so thank you for that.

00:18:06.300 | Let's go on to the next thing, which is non-profit organizations.

00:18:09.180 | Here, a lot of us are asked to sit on non-profit organizations and we're asked to be on the

00:18:14.420 | finance committee and maybe on the investment committee, where we're going to oversee the

00:18:18.980 | foundation or the endowment.

00:18:21.460 | What duties do we have there and what laws oversee endowments and foundation fiduciary

00:18:31.700 | duty?

00:18:32.700 | Basically, the same thing.

00:18:34.900 | You've got your two primary duties, the duty of prudence, the duty of loyalty.

00:18:39.700 | It doesn't matter what the investment is.

00:18:44.260 | When you get into a situation involving a non-profit, I strongly recommend that you

00:18:52.540 | hire outside counsel, and by counsel, I don't mean attorney, but I mean someone who is more

00:19:00.380 | experienced and knowledgeable in the investment industry.

00:19:04.520 | When you do that, you have to be very objective in analyzing the analyst.

00:19:12.380 | Again, I think one of the important points that I always make to people on non-profits,

00:19:19.060 | you can bring in third parties to help you analyze investments and to make recommendations,

00:19:25.380 | but the ultimate responsibility and liability is yours.

00:19:31.060 | It's important to go back to the two-step process I talked about before.

00:19:36.260 | Whatever recommendations a third party makes, the board itself has got to make the ultimate

00:19:45.700 | decision and has to be able to analyze investments to determine if they are or are not prudent.

00:19:53.100 | One of the important things about the restatement of trust, a lot of times, professional investors,

00:20:01.620 | professional counselors, will look at the portfolio as a whole, but fiduciaries are

00:20:08.760 | analyzed not only with regard to the portfolio as a whole, but each individual investment,

00:20:16.540 | so it's important for anyone serving on a board to learn some basic fundamentals.

00:20:24.260 | Simplest one is what I talked about before, cost efficiency or inefficiency.

00:20:30.700 | Something that's important is a lot of professional counsel or advisors will recommend actively

00:20:38.140 | managed funds.

00:20:39.740 | Unfortunately, the research shows that most actively managed funds do not outperform index

00:20:46.660 | funds and are therefore cost inefficient.

00:20:50.460 | Cost inefficiency is a violation of your fiduciary duty and will result in liability.

00:20:57.220 | So let me give you a case.

00:20:59.460 | This happened to me more than once.

00:21:02.020 | I am asked to go to a non-profit organization, say a private school, and give a presentation

00:21:13.680 | about low-cost index investing because someone on the board wants to educate the other people

00:21:21.040 | on the board.

00:21:23.140 | So they're interviewing advisors to take over the management of their endowment, say a million

00:21:30.780 | dollar endowment.

00:21:33.260 | Back when I was managing money, and I don't do that anymore, but back when I was, I was

00:21:37.500 | asked to come in to be the passive indexing alternative.

00:21:42.940 | And I learned after doing this a few times and not getting the account, I learned to

00:21:49.100 | ask who else is on the board besides the person who wanted me to come in, and what affiliations

00:21:56.740 | do they have with the local community, and also what company or what advisor or what

00:22:05.020 | bank is currently managing the money.

00:22:08.480 | Because nine times out of ten, if it's somebody local and they have some sort of a connection

00:22:13.560 | to that board, it's really difficult to move them off of that local advisor or local bank.

00:22:23.940 | And I'll give you one example.

00:22:26.140 | This one school had a local bank managing their portfolio, charging them 1% fee or some

00:22:35.720 | ridiculous thing, and they were not doing well.

00:22:40.020 | It was all active management.

00:22:41.660 | It was clear they were not doing well.

00:22:44.460 | But they didn't want to leave this bank because the bank every year held a fundraiser for

00:22:51.900 | the school, and they raised like $10,000 in a golf tournament, and they gave that money

00:22:58.460 | to the school.

00:23:00.500 | And they were afraid that if they fired the bank, that they'd lose that fundraiser, and

00:23:08.540 | the money that they took in from the fundraiser was greater than the money that they were

00:23:12.860 | losing by not being in index funds.

00:23:15.980 | Wow.

00:23:16.980 | How do you read into that one?

00:23:17.980 | That's an interesting one.

00:23:18.980 | I thought I had an answer until you threw in that last part about the benefit.

00:23:25.140 | I mean, I couldn't fault them.

00:23:26.260 | It's like, okay, I understand why you continue to use this bank, because they're raising

00:23:29.760 | money for you and they're giving money to the school, so net-net, you're coming out

00:23:33.660 | ahead even though the bank does a lousy job managing the money.

00:23:37.740 | You know, I'm going to disagree with you there.

00:23:39.580 | It isn't a net-net, because remember what I said that the fiduciary has a responsibility

00:23:49.460 | to act solely on the benefit.

00:23:52.580 | So the members of the board of the school have a responsibility to act solely for the

00:24:00.020 | benefit of the school, and even if the proceeds from the charity event exceed the loss, if

00:24:10.020 | I were the attorney in that case, if one of the members came to me and said, "What do

00:24:14.300 | we do?"

00:24:15.300 | My argument would be, I don't have to incur that loss, whether it be you or anyone else.

00:24:22.860 | As the member of the board, that fiduciary has a responsibility to look solely at the

00:24:28.500 | results produced by the bank serving as the fiduciary.

00:24:33.780 | I know what you said about the fact that the benefit produced more money, but if I'm the

00:24:41.600 | attorney for the school, I'm going to argue that's an unnecessary loss.

00:24:47.020 | I can find some, and my argument, my personal argument would be, I can find somebody else.

00:24:53.140 | I'm pretty sure Rick can find somebody to help produce that benefit and not lose money.

00:25:00.180 | So from a legal perspective, bottom line for me is, you're unnecessarily losing money,

00:25:08.380 | and that's just not acceptable in a fiduciary role if it's preventable.

00:25:12.540 | Now, sometimes, you know, things happen like 9/11, and things happen, but based upon what

00:25:19.200 | you're telling me right now, this was pretty much a situation where they were annually

00:25:24.540 | losing money and agreeing to lose that money in order to get the money from the golf tournament.

00:25:33.500 | I can tell you right now, I can't imagine a court not ruling that that's a fiduciary

00:25:39.260 | breach.

00:25:40.780 | Just to clarify, they weren't losing money.

00:25:42.100 | They were just underperforming index funds by just about the amount they were getting

00:25:46.220 | from the golf tournament.

00:25:48.340 | But anyway, these conflicts of interest in these, you know, small endowments and foundations

00:25:53.180 | where the people sitting on the board are brokers, you know, or some other insurance

00:25:59.060 | agents or something like that, because they're not investment experts.

00:26:03.220 | They're salespeople.

00:26:04.540 | I find them to be really problematic, and, you know, they have the right to sit on the

00:26:09.520 | board, but how well informed is everyone else on the board?

00:26:15.020 | Ultimately that's the real problem.

00:26:16.020 | I'm not going to get into details, but there was a very famous case involving New York

00:26:20.660 | University and their 403(b) plan, and that was exactly the situation.

00:26:26.900 | They're called third party administrators.

00:26:28.780 | They basically oversee and manage a 401(k) account, and it was a very well company.

00:26:34.900 | When the case was going to court, testimony came out that a lot of the members of the

00:26:41.820 | investment committee on the NYU board had no idea about investments.

00:26:48.320 | Some of them didn't even know they were on the investment committee or on the board.

00:26:53.340 | That's not an unusual situation, and quite often I'll see a board like you said that

00:26:58.540 | either has the actual investment company, the mutual funds representative on the board,

00:27:06.020 | but I point out to the other fiduciaries you've got a responsibility not to let one member

00:27:12.720 | bully you.

00:27:13.720 | I hate to keep going back, but it's an important point that a fiduciary, each individual fiduciary

00:27:20.940 | has an individual responsibility to ensure that they're doing their job in ensuring that

00:27:28.860 | prudent investments are what are being chosen, not because of somebody's, what they do for

00:27:36.000 | a living or affiliation with a bank or anything like that.

00:27:40.180 | So each individual fiduciary has to understand, and it takes someone like you or me to remind

00:27:47.060 | them you're going to be held responsible.

00:27:50.500 | So you can't sit over here and say, "Well, I just deferred to him."

00:27:54.180 | You can't do that.

00:27:57.020 | Let's move on to the next subject, which is the advisors, and these are the registered

00:28:03.700 | investment advisors and the brokers.

00:28:08.740 | How do you split up this world?

00:28:13.140 | There are those who have fiduciary duty, those who don't have fiduciary duty, those who accept

00:28:19.060 | some fiduciary duty for some of the things they do, but don't accept fiduciary duty for

00:28:23.620 | other things that they do.

00:28:25.300 | Could you explain all of this?

00:28:27.740 | Defining fiduciary duties vis-a-vis investment advisors is the easy part.

00:28:34.340 | The law is very settled.

00:28:36.180 | They have the same responsibilities we've been discussing, prudence and loyalty.

00:28:42.500 | It's that cut and dried.

00:28:45.160 | On the broker side, we're right in the middle of a change in the law.

00:28:50.620 | Historically, there have been two standards.

00:28:53.740 | If you're an investment advisor, you have a duty of absolute fiduciary duty.

00:29:00.980 | Brokers on the other hand, were held to a standard of suitability.

00:29:06.940 | People often ask me, "What's the difference between suitable advice and prudent advice?"

00:29:16.740 | I think the best definition I heard was suitable advice is okay, kind of okay.

00:29:25.780 | Whereas fiduciary advice has to be the best advice.

00:29:29.940 | It has to be in your best interest.

00:29:33.380 | Broker dealers, I mean brokers under the suitability standard could put their interest ahead of

00:29:41.660 | their customers.

00:29:42.660 | We're in the middle of a change right now.

00:29:46.060 | Back in 2020, the Securities and Exchange Commission enacted a new rule because of all

00:29:51.180 | the criticism of the suitability standard.

00:29:55.580 | Right now, brokers are under what's called reg best interest.

00:30:03.480 | We don't have time to go into all the nuances, but I'll tell you that basically what we've

00:30:07.780 | got now under reg best interest, they don't have the high level of responsibility that

00:30:18.380 | fiduciaries have.

00:30:20.940 | But the problem is that when the SEC enacted reg BI, they didn't define best interest.

00:30:28.440 | So that's where we stand right now.

00:30:30.180 | Are we using a common sense concept of best interest or is the SEC and they've recently

00:30:38.380 | said they're going to do this, they're going to define what best interest is.

00:30:43.860 | So right now, brokers have a responsibility that's somewhere between the low level of

00:30:51.180 | suitability versus the high level of fiduciary prudence.

00:30:56.420 | But arguably, they have a higher standard now because the main element in reg best interest

00:31:02.860 | that they didn't have under the suitability standard is now they have to consider costs.

00:31:08.940 | Okay, so you have somebody, they're both a broker dealer and they're also a registered

00:31:14.100 | investment advisor.

00:31:16.340 | Part of the portfolio that they're managing is under an RIA agreement.

00:31:21.060 | And part of the investments that are being managed are under the brokerage agreement.

00:31:25.280 | So they might say in a court case or an arbitration against them that, well, that particular account

00:31:33.900 | is not a fiduciary relationship.

00:31:36.420 | Only this account is a fiduciary relationship.

00:31:41.420 | One of my previous jobs was to serve as a compliance director for a very large independent

00:31:48.740 | broker dealer.

00:31:50.580 | Bottom line is brokers argue that they don't have a fiduciary duty, but that's been the

00:31:55.960 | typical argument.

00:31:57.660 | We don't have a fiduciary duty.

00:32:00.800 | Investment advisors do.

00:32:02.360 | So they try to draw this mythical two hats argument.

00:32:07.400 | Brokers are allowed by most broker dealers to either form their own independent RIA or

00:32:14.600 | a lot of brokers don't want that hassle.

00:32:17.140 | They don't want management.

00:32:18.380 | They just want to get money from providing those services.

00:32:22.640 | So most broker dealers in this country now have a proprietary registered investment advisor

00:32:28.960 | that the broker can join and offer the same advisory services that other investment advisors

00:32:36.120 | provide.

00:32:38.200 | So they can get there and do it easily by working under the broker dealers RIA.

00:32:46.000 | The term in the industry is duly registered.

00:32:49.800 | So if you are registered with both a broker dealer and an investment advisor, to answer

00:32:55.280 | your question, there was a 1949 case, so what I'm about to tell you isn't new.

00:33:00.960 | It's been around for over 50 years, actually 60, 70, anyway, what the court said is that

00:33:08.960 | if you're a stock broker and you also provide investment advisory services, you confuse

00:33:16.760 | your client.

00:33:18.640 | And the court said, we're not going to let you confuse the client.

00:33:21.600 | If you're in a situation where you provide services, both as a stock broker and an investment

00:33:26.640 | advisor, you're held to the higher standard, that being the fiduciary standard.

00:33:32.680 | Oh, interesting.

00:33:34.640 | The last area that I want to touch upon are pension funds, and this would include qualified

00:33:41.640 | plans.

00:33:42.640 | They fall under ERISA.

00:33:45.440 | Could you explain how they're special?

00:33:48.560 | ERISA is the law that governs, as you said, pension plans, 401(k) plans, 403(b) plans,

00:33:58.160 | and it imposes a very heavy responsibility on the fiduciary of those plans.

00:34:05.180 | Again, it's the same duties we talked about beforehand, prudence and loyalty.

00:34:12.960 | But I'm a golfer, and as I like to tell 401(k) boards, there are no mulligans under ERISA.

00:34:21.900 | You either do right or you do wrong, and one of the famous quotes that came out of a 401(k)

00:34:30.000 | case, and judges like to throw this out, "If you as a fiduciary make a mistake and it costs

00:34:38.200 | the plan, you're responsible."

00:34:41.560 | And typically, the fiduciaries for the plan will say, "Well, we didn't mean any harm."

00:34:46.720 | And this is the quote that the courts like to use, "A pure heart and an empty head are

00:34:52.580 | no defense."

00:34:54.620 | I want to get into recent court cases, because I understand the Supreme Court is in the middle

00:35:00.160 | of deciding something relatively important for the trustees of 401(k) plans.

00:35:05.780 | Could you get into what the Supreme Court is working on?

00:35:09.520 | The case before the Supreme Court, 401(k) beneficiaries, the plan participants, filed

00:35:16.900 | a lawsuit against Northwestern University, and they made the allegations that the investments

00:35:23.860 | were imprudent, they lost money.

00:35:27.580 | The case was thrown out in the lower court, and the case went all the way to the Supreme

00:35:32.820 | Court, and the Supreme Court decided to hear it.

00:35:36.820 | There were two main issues before the court.

00:35:40.860 | The lower court had thrown out the case because they had said that the attorneys for the plan

00:35:46.020 | participants didn't make the necessary disclosures or allegations.

00:35:53.700 | The second issue, and to me, the bigger issue, was the judge in the lower court had dismissed

00:36:00.500 | the case because he said that the plan had included both proper and improper mutual fund

00:36:09.700 | investments.

00:36:10.700 | And so, Lee called the menu of options defense.

00:36:15.380 | He said, "As long as you offer some that are good and some that are bad, it's okay.

00:36:20.380 | One bad apple doesn't spoil the whole thing."

00:36:23.100 | Well, the judge was wrong.

00:36:26.080 | And so, the court took on the issue of whether or not a plan can offer both bad and good

00:36:34.020 | investments, suitable, unsuitable investments, cost-inefficient investments.

00:36:42.260 | To me, that's the bigger issue because a lot of courts, federal courts, have been dismissing

00:36:49.500 | cases and denying the participants who've been hurt their day in court.

00:36:56.100 | We obviously don't know what the court's going to say in this case, but hearing Justice Kagan

00:37:03.660 | really got into questioning the attorney for Northwestern University and pointing out to

00:37:10.740 | him that this didn't make any sense, and in fact, it's contrary to ERISA, what we talked

00:37:18.060 | about before, the law that covers plans.

00:37:23.460 | And she really got to the nitty-gritty and asked the attorney for Northwestern.

00:37:27.980 | She goes, "This whole idea that you can include and offer bad and good investments, you don't

00:37:33.260 | believe that, do you?"

00:37:35.020 | And the attorney admitted, "No."

00:37:37.500 | And yet, almost every 401(k) plan, 403(b) plan that I look at has some index funds in

00:37:47.340 | it, which are good because you can pick them out and you can say, "Let's use just those

00:37:51.300 | index funds."

00:37:52.300 | And it has a variety of higher cost funds that look like legacy type investments.

00:38:01.940 | Now, not all 401(k)s have this.

00:38:04.300 | I've noticed that the newer companies, a lot of the newer tech companies, they don't have

00:38:08.540 | any of this old legacy active management stuff in there.

00:38:12.980 | It's the older companies where these funds are hanging around in there, and they probably

00:38:19.380 | have accumulated a lot of assets over the years.

00:38:21.940 | And maybe there's a reluctance to take them out because a lot of beneficiaries are invested

00:38:27.700 | in those funds.

00:38:28.700 | I mean, is that part of the consideration?

00:38:30.500 | I think there are two considerations here.

00:38:33.460 | Strangely enough, ERISA talks about financial retirement readiness and buzzwords like that.

00:38:42.060 | But inexplicably, ERISA does not require that an employer provide investment education for

00:38:50.620 | its employees.

00:38:52.620 | So I think the reason a lot of those old time actively managed funds are in there is because

00:39:00.580 | the employees simply don't know how to properly evaluate a fund and don't know that the fund

00:39:07.620 | may not be in their best interest.

00:39:10.460 | I think the second issue is from a legal perspective, I've talked to a lot of plan CEOs of corporations

00:39:20.620 | and the investment committees of their 401(k) plans.

00:39:25.500 | And from a practical perspective, the CEOs say, well, we're not going to go in and take

00:39:31.120 | out the bad funds because if we do, then we're going to get sued.

00:39:40.260 | And I have to tell them, you've got a point if you want to try to explain it away.

00:39:45.940 | But I tell them, if you don't take them out, then you're going to have that specter of

00:39:50.780 | liability hanging over you forever.

00:39:54.260 | So from a practical perspective, they don't want to get sued.

00:39:59.220 | But you're not doing right by the participants, and it clearly violates the stated purpose

00:40:05.200 | of ERISA, and that is to help protect the financial wellness and retirement readiness

00:40:12.260 | of the plan participants.

00:40:14.180 | Is there some sort of a safe harbor for this lawsuit?

00:40:17.620 | I think it's under 404(c).

00:40:21.020 | There is.

00:40:22.020 | 404(c) says that if you comply with these 20 requirements, then you're not, you being

00:40:29.340 | the plan, are not responsible for the actual performance of those investments.

00:40:34.680 | So you have immunity.

00:40:36.920 | And that's why a lot of the plans try to go for it because then, once they provide the

00:40:43.580 | employees with these various investment options, they're not responsible whether the performance

00:40:49.120 | is good or bad.

00:40:51.240 | But Fred Rice, who's one of the leading ERISA attorneys, is on record.

00:40:55.260 | He testified before the Department of Labor.

00:40:58.800 | And Fred's been around as long as I have, 40 years, and Fred said that in all his years,

00:41:04.240 | they have never found a 401(k) plan that satisfied the 20 or more requirements to become eligible

00:41:12.780 | for 404(c).

00:41:15.040 | So practically speaking, yes, there is a safe harbor.

00:41:19.560 | But once a plan tries to apply for it, they find out they're not in compliance with ERISA.

00:41:27.600 | Interesting.

00:41:28.600 | Are there any other noteworthy court cases that occurred in the last couple of years

00:41:33.440 | that you'd like to bring up?

00:41:35.200 | Yeah, I'd like to bring up the case of Brotherston versus Putnam Investments.

00:41:44.160 | It was a First Circuit Federal Court of Appeals case.

00:41:48.280 | And the reason it's important is that it was one of the few instances where a court, instead

00:41:53.520 | of trying to protect Wall Street, went out of its way to protect plan participants.

00:41:59.800 | And Brotherston's noteworthy for a couple of reasons.

00:42:04.120 | First and foremost, it ruled in favor of the plan participants.

00:42:09.440 | The lower court judge had said, "You can't compare actively managed funds to index funds

00:42:16.020 | because index funds will always win.

00:42:18.440 | They've got lower costs."

00:42:21.360 | And the First Circuit Court of Appeals went to the Restatement of Trusts, Section 90,

00:42:29.400 | which is known as the Prudent Investor Act, Prudent Investor Rule, Comment M in the Restatement

00:42:37.280 | says, "You can compare index funds and active funds."

00:42:41.560 | So this was one of the few times I can ever remember any court, federal court, state court

00:42:47.600 | saying index funds are fine.

00:42:51.240 | And then to build on that, the First Circuit Court of Appeals told the broker-dealers and

00:42:58.680 | the investment advisors and mutual fund companies, "I know you're not going to be happy with

00:43:03.400 | that ruling, but you know what?

00:43:06.000 | There's an easy way to avoid this whole mess, invest in index funds."

00:43:11.400 | So that's a really big ruling.

00:43:15.160 | And when you combine the court saying it isn't apples and oranges, you can compare actively

00:43:23.040 | managed funds and index funds, when you combine that with the ruling that we all expect the

00:43:30.480 | Supreme Court to make, i.e. that there is no menu of options, each individual investment

00:43:37.760 | has to be prudent.

00:43:39.800 | That's going to pretty much help protect plan participants because it's going to hold the

00:43:46.480 | members of the investment committee and the plan sponsor to making decisions based solely

00:43:53.200 | on the merits of the investments.

00:43:55.440 | Let me ask one question before we move on to your book, and that has to do with target

00:44:00.680 | date retirement funds and defaulting investors into target date retirement funds.

00:44:09.000 | Number one question is, you know, good idea or not good idea?

00:44:12.760 | And number two, I've seen some pretty expensive target date retirement funds, and I've seen

00:44:17.360 | some pretty inexpensive target date index retirement funds.

00:44:23.120 | Why would you have actively managed target date retirement funds when you have index

00:44:28.240 | retirement target date retirement funds?

00:44:30.720 | Again, I'm going to give the answer that the investment committee choosing between the

00:44:37.120 | target funds doesn't understand, doesn't know how to do the basic cost benefit analysis.

00:44:46.080 | Plain and simple.

00:44:47.640 | My feelings on target date funds, I'm not a big fan of them, two primary reasons.

00:44:53.240 | The way most target date funds work is that as you get older and closer to approaching

00:45:00.640 | retirement, they gradually reduce the equity exposure.

00:45:07.480 | In a lot of cases, you may be exposing to people that own those target date funds to

00:45:13.400 | more risk than A, they want or B, that they need.

00:45:19.600 | The other issue that I don't think a lot of people understand about target date funds

00:45:24.680 | is that typically a target date fund does not provide the same level of active management

00:45:32.040 | that an investment advisor or an actively managed fund management does.

00:45:39.360 | Most of these target date funds, one reason they can offer lower costs, but like you said,

00:45:46.160 | a lot of them have higher costs.

00:45:48.200 | But one reason that they can offer lower costs is that the fund basically only rebalances

00:45:56.560 | or adjusts the equity or the investments in the fund once a year.

00:46:04.280 | So take for instance, right now, we've seen a lot of increasing instability in the market.

00:46:11.760 | And a lot of people are saying, well, I'm going to reduce my equity exposure a little

00:46:17.680 | bit.

00:46:18.880 | Some people are saying get out altogether, I don't agree with that.

00:46:22.720 | But target date funds do not allow that opportunity except maybe once a year to adjust.

00:46:33.080 | So if you want to adjust even just a little bit, you've got to wait till the date that

00:46:38.040 | they say we're going to go back in and adjust.

00:46:41.560 | One of the reasons I don't like target date funds is that they don't provide enough risk

00:46:46.520 | management opportunities for an investor.

00:46:50.280 | And Charles Ellis, who's a well-known investment advisor, has stated that the real secret of

00:46:56.600 | successful investing is risk management, not the selection of investments.

00:47:03.040 | Let's move on to your book, the 401(k), 403(b) Investment Manual, What Planned Participants

00:47:10.080 | and Planned Sponsors Really Need to Know.

00:47:12.360 | The second edition just came out.

00:47:15.440 | First edition was published back in 2010.

00:47:17.960 | There's just a tremendous amount of information in here for small business owners who have

00:47:23.480 | 401(k) plans and what their duties are and so forth.

00:47:26.800 | But could you explain or talk about some of the highlights of your book?

00:47:32.280 | Sure.

00:47:33.280 | The reason I wrote the book is, as I mentioned earlier, ERISA does not require 401(k), 403(b)

00:47:42.200 | plans to provide investor education.

00:47:45.480 | There have been numerous studies showing that investors in general are not very knowledgeable

00:47:52.840 | about how to manage their investments.

00:47:55.080 | In fact, I had a CEO, I gave a presentation at a conference once.

00:48:01.320 | And after the presentation, a CEO came up to me and complimented me on the presentation.

00:48:08.640 | And he said, "I'll never voluntarily offer investor education in my company."

00:48:14.200 | And I kind of gave him a look and he goes, "If I educate them, they'll realize how bad

00:48:19.840 | our plan is.

00:48:21.920 | And then you and the other attorneys will come in and sue us."

00:48:26.160 | The reason I wrote the book was, I've tried to cover as many topics as possible, primarily

00:48:34.280 | about investments that are often chosen for 401(k), 403(b) plans.

00:48:41.360 | But as we've talked about earlier, one of the big problems with these 401(k), 403(b)

00:48:47.920 | plans is that the investment committee members themselves don't know how to properly choose

00:48:54.960 | investments.

00:48:55.960 | So, that was the reason I wrote the book.

00:48:59.240 | I had several people ask me after giving presentation, education presentations for 401(k) plans or

00:49:08.760 | at conferences, they said, "Okay, loved your presentation.

00:49:13.080 | Why don't you share that information with everybody?"

00:49:17.200 | So that's the purpose of the book.

00:49:19.640 | It's relatively short.

00:49:21.020 | I'm a firm believer based on my own preferences that if a book is more than 100 pages, it's

00:49:28.160 | probably going to get be placed down and you're going to forget about it.

00:49:32.440 | So it's slightly over 100 pages, and we're just trying to provide in simple, plain English,

00:49:39.480 | some techniques, some concerns that you should look at in deciding on the various investment

00:49:48.720 | options.

00:49:49.720 | And even though it does say 401(k), 403(b), it's equally applicable to just your regular

00:49:56.560 | brokerage accounts or any kind of situation where you're going to be dealing with investments.

00:50:02.640 | You also have a website, investsense.com, where you publish a blog every month with

00:50:07.540 | some great information, not just on retirement plans, but financial plans, broker, dealers,

00:50:13.320 | advisors, and you name it, the whole gamut.

00:50:15.840 | We do.

00:50:16.840 | And then quite often I'll speak or be called in to help a 401(k) plan like you yourself.

00:50:24.280 | And they said, "We need a blog."

00:50:26.640 | So we have a second blog that's more oriented toward investment professionals and 401(k),

00:50:34.440 | 403(b) members.

00:50:36.000 | The other one is more consumer oriented.

00:50:38.900 | The second blog is more oriented toward investment fiduciaries.

00:50:44.480 | And is that also on investsense.com or is that a different website?

00:50:48.360 | No.

00:50:49.360 | The second website is called the Prudent Investment Fiduciary Rules and it's at IAINSIGHTwordpress.com.

00:51:03.080 | Any last words, Jim, that you want to impart on us?

00:51:05.400 | I mean, you've got 40 years worth of experience, you've been around, you've seen it all, you

00:51:12.200 | know what's right, you know what's wrong, you know where people hide behind.

00:51:17.760 | Any final words?

00:51:18.760 | A lot of people say they're intimidated by the idea of investing.

00:51:25.320 | Don't be.

00:51:26.320 | As I said earlier, I think the simplest way to determine the prudence of an investment

00:51:31.280 | is simply to do a cost-benefit analysis.

00:51:34.040 | It's the same thing that we learn, cost-benefit and Econ 101.

00:51:40.540 | Just compare the incremental costs of an investment vis-a-vis actively managed versus an index

00:51:48.280 | fund.

00:51:49.700 | Compare the incremental costs to the incremental returns.

00:51:53.600 | And if the incremental costs are greater than the incremental returns or the actively managed

00:52:00.480 | fund does not outperform the index fund, then don't invest in it.

00:52:06.400 | Jim, it's been great having you on Vocal Heads on Investing.

00:52:09.760 | Thank you so much for your time today and I appreciate all the wealth of knowledge that

00:52:14.760 | you've given us.

00:52:15.760 | Thank you, Rick.

00:52:16.760 | I appreciate you having me on.

00:52:18.620 | This concludes Episode #41 of Vogel Heads on Investing.

00:52:22.520 | Join us each month as we have a new guest and talk about a new topic.

00:52:26.320 | In the meantime, visit VogelHeads.org and the Vogel Head Wiki.

00:52:31.160 | Check out the Vogel Heads new YouTube channel, Vogel Heads Twitter, Vogel Heads Facebook,

00:52:37.320 | and find out about your local Vogel Heads chapter and tell others about it.

00:52:42.040 | Thanks for listening.

00:52:43.200 | [Music]

00:52:52.200 | (upbeat music)

Bogleheads® on Investing Podcast Episode 041 – James Watkins, lll, JD, host Rick Ferri (audio only)

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