What Does the Best Interest Standard of Care Require?

This is my 64th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The best interest standard of care is found, among other places, in the Best Interest Contract Exemption (BICE). The standard is a combination of ERISA’s prudent man rule and duty of loyalty. In fact, in the prudence portion of the definition, the only change is that the words “prudent man” are changed to “prudent person.” But, that begs the question, what does the prudent person rule require?

Generally speaking, it requires the following:

  • A prudent process by a hypothetical knowledgeable person who obtains and evaluates the information needed to make a careful and skillful decision.
  • With regard to investments, it requires that fiduciary advisors adhere to generally accepted investment theories. DOL guidance is clear that, in interpreting the best interest standard of care, fiduciaries are to look to ERISA’s history. And, ERISA’s history confirms that generally accepted investment theories are to be used. Again, though, what does that mean? Among other things, it means that IRA owners and plan participants should be advised to invest in a portfolio with asset allocation based on their needs, objectives and circumstances. The DOL explained in the preamble to its participant investment advice regulation (§2550.408g-1) that:

“After careful consideration of all the comments on the issue, the Department does not believe it has a sufficient basis for determining appropriate changes to the generally accepted investment theory standard. While several commenters described theories and practices they believe to be generally accepted, there did not appear to be any consensus among them, with the exception of modern portfolio theory,22 which the Department believes is already reflected in the rule’s reference to investment theories that take into account the historic returns of different asset classes over defined periods of time.

22This is consistent with a survey of literature on generally accepted investment theories prepared for the Department. See Deloitte Financial Advisory Services LLP, Generally Accepted Investment Theories (July 11, 2007) (unpublished, on file with the Department of Labor).”

  • It is hard to imagine that broader concepts of diversification would not also be considered to be generally accepted investment theories. For example, even though portfolios may be diversified among asset classes, there is an argument that the investments in each asset class should also be diversified. While this is an issue for investment experts, and not for lawyers, it seems fairly obvious that diversification by asset class and within asset classes would be, at the least, good risk management. Keep in mind that IRAs are retirement vehicles. As a result, IRAs should be invested in a manner consistent with retirement investing, which suggests, among other things, the avoidance of large losses. That is particularly true for older IRA investors.

However, in the final analysis, the retirement investor gets to decide how his money will be invested. While advisors may be obligated to recommend investment strategies that are consistent with generally accepted investment theories, a retirement investor can override those recommendations and direct that the account be invested differently. In that case, a fiduciary advisor is well-advised to obtain written directions from the retirement investor about how the investor wants the account to be invested. Armed with that direction the fiduciary advisor’s duty is to provide advice within the limits imposed by the retirement investor.

The application of fiduciary, or best interest, concepts to individual retirement investors will be new for many advisors. As a result, advisors, and their supervisory entities, should focus on the fiduciary requirements for a prudent process and for the application of general accepted investment theories.

Forewarned is forearmed.