Ed. Note: This article first appeared in MarketWatch
Can a robo adviser act as a fiduciary? It might not rank with the all-time great philosophical questions, but financial experts are increasingly wondering that very thing.
They especially want to know whether a robo adviser can act as fiduciary under the Labor Department’s conflict-of-interest rule which, given this month’s announcement, is now scheduled to take effect June 9.
In one camp, there are those who say most robo advisers already act as fiduciaries. Most if not all are registered investment advisers and must — as required by the Investment Advisers Act of 1940 — act in the best interests of their clients and provide investment advice in their clients’ best interests. RIAs owe their clients a duty of undivided loyalty and utmost good faith according to the SEC.
What’s more, RIAs that work in the 401(k) market must comply with the Labor Department’s fiduciary rules established by the Employee Retirement Income Security Act of 1974 (ERISA). Those laws state that those who have discretionary control over a retirement plan or who provide investment advice to retirement plans and plan participants are fiduciaries.
In the other camp, there are those who say it’s impossible for robo advisers to act as fiduciaries be it under the SEC and/or Labor Department’s laws. “People have duties, said Elliot Weissbluth, founder and CEO of HighTower. “Machines have functions. Machines don’t yet have the capacity to discharge a duty to a human being.”
So who’s right? The robo advisers say there’s really no debate, especially since Christopher Jones, the chief investment officer of Financial Engines, a robo adviser in the 401(k) market, was part of the panel when the rule was first announced last year.
“As the ‘original robo adviser, ’Financial Engines has always served as a fiduciary for our clients and strongly supports the fiduciary rule,” said Mike Jurs, director of public relations for Financial Engines.
“(We) can absolutely be a fiduciary and we’ve been very vocal of our support,” said Joe Ziemer, vice president of communications at Betterment, who went on to note Senator Elizabeth Warren (D-Mass.) support of Betterment.
Senator Warren has been among the leading lawmakers supporting the Labor Department’s new conflict-of-interest rule, and the role robo advisers have in delivering advice to retirement account owners. Read .
Ziemer also noted a white paper, commissioned by Betterment, that supported the reasons why a robo adviser can be a fiduciary under the Labor Department’s new conflict-of-interest rule.
And Ziemer noted what he thought to be the big difference between robo advisers such as Betterment and other robos: They aren’t selling their own products.
“We do not make our own products and receive no compensation for them,” he said, noting that some firms are “heavily incentivized to push you into their own products. We pick the best the funds regardless of who makes them.”
For his part, Knut Rostad, president of Institute for the Fiduciary Standard, said the Labor Department blessed robo advisers in its Conflict of Interest FAQ issued last October.
That document noted, among other things, that “robo advice is still evolving in ways that appear to avoid conflicts of interest that would violate the prohibited transactions provisions and that minimize cost.”
Possible gray areas
Other experts, however, aren’t so sure. “I’m not 100% certain,” said Bill Winterberg, founder and president of FPPad.com, who notes a passage from the Federal Register that states that “a financial institution and its advisers must 1) give prudent advice that is in the client’s best interest (i.e. prudent advice based on the client’s investment objectives, risk tolerance, financial circumstances, and needs, without regard to financial or other interests of the financial institution or adviser).”
“By design, customers of a robo adviser answer only the questions that are presented by the robo adviser’s service,” said Winterberg. “By definition, the questions asked by the service are limited to a very narrow segment of the client’s financial circumstances.
The questions are not all encompassing of all aspects of a customer’s financial situation.”
So, who defines, asked Winterberg, the level of suitable knowledge of a customer’s financial circumstances? The courts? The Labor Department?
“That is why I am not certain about robo services complying with the principle of the Labor Department language,” he said. “Who defines the amount of information required to generate advice that meets a ‘prudent” definition? Again, I am not certain.
Others, including government regulators, are also concerned. William Galvin, secretary of state for Massachusetts, last year issued a policy statement stating that “fully-automated robo advisers, as they are typically structured, may be inherently unable to act as fiduciaries and perform the functions of a state-registered investment adviser.”
Galvin further said in a statement made at the time: “Entities that create computer-generated portfolios but fail to do the necessary due diligence to know their customers and who specifically decline most if not all the fiduciary duty are not performing the duties of investment advisers.”
So, where does this leave advisers? Should they use a robo for their retirement-account clients once the Labor Department’s conflict-of-interest/fiduciary becomes the rule of the land? What are the pros and cons?
Most independent experts advise caution.
“It really depends on the level of customization and how well they (the robos) actually ‘know the customer,’” said Scott Smith, a director at Cerulli Associates. “If these levels are low—aren’t robos just fancy versions of target-date funds masquerading as customized portfolios?”
“Pure robos are algorithms that provide outputs based on a fairly limited amount of information provided as inputs,” said Rostad. “They serve a purpose in many instances, but do not directly substitute for a true adviser.”
And Winterberg said average investors need to know that the advice rendered by a robo adviser service is significantly limited in scope and generally applies only to the level of risk in the customer’s portfolio.
“Robo adviser services do not offer advice on debt management, cash flow management, estate planning, tax planning, and the like,” he said.
“This limited scope of advice is one of the disadvantages of engaging a robo adviser service because, in my opinion, what investors don’t know they don’t know about the risks of investing can be extremely hazardous and detrimental to their financial future. It’s like driving a car without ever taking the time to check any of the vehicle’s blind spots.”
Posted by: The Trust Advisor