Although robotic advice is viewed by many as a major new source of opportunity, it also presents plan fiduciaries with challenges such as choosing an appropriate robo-adviser that can comply with the pending Department of Labor (DOL) conflict of interest rule, which extends fiduciary responsibility to virtually anyone offering advice in a retirement plan. But can robots serve effectively as fiduciaries? Global law firm Morgan Lewis argued this point in its white paper “The Evolution of Advice: Digital Investment Advisors as Fiduciaries.”
The firm believes robo-advisers can act as fiduciaries under existing regulations imposed by the Securities Exchange Commission (SEC)—including the Investment Advisers Act of 1940—and by the DOL, “because they are essentially offering the same services conducted by human advisers.” Moreover, Morgan Lewis argues that the applicable standard of care is not an absolute concept, but rather a flexible one that is “defined by contract” and extends only to the “scope of service agreed to by the client.”
Still, critics argue that machines may not be able to gather enough information to give sound, individualized investment advice to meet certain goals such as saving for retirement.
“The debate is how much information should you collect, and what [do] you need to collect, to determine whether any advice is appropriate for any particular investor,” suggests Jennifer Klass, one of the paper’s co-authors. “Our position has been that adviser(s) can solicit as many or as few questions as they feel are appropriate.”
Morgan Lewis also believes robo-advisers, by design, can present fewer potential conflicts of interest than delivered by other approaches to advice. Many robo-advisers are essentially automated managed accounts with portfolios composed mostly of exchange-traded funds (ETFs). The firm believes that ETFs, “in comparison with mutual funds, offer little room for revenue streams and payment shares that would otherwise create a conflict of interest for investment advisers (e.g., 12b-1 fees, sub-transfer agent fees).”
Of course, regulating algorithm-based machines would be different than scrutinizing individual advisers. The Financial Industry Regulatory Authority (FINRA) explores this concept among other topics in its recent publication “Report on Digital Investment Advice,” which analyzes best practices for broker/dealers (B/Ds).
To remain compliant, FINRA advises that a broker/dealer should understand the algorithms that govern digital investment tools and should ensure the methodology it uses to translate inputs into outputs reflects the firm’s analytical approach to particular tasks—e.g., investor profiling and account rebalancing. FINRA also argues that firms should understand the assumptions that are made by these machines during “shock events” such as global recessions or a geo-political crisis.
This supervision extends to the portfolios that digital investment tools may present to participants based on risk profiles. FINRA advises a firm to disclose if the tool favors certain securities along with the reasoning behind its selectivity and whether other investments may have “characteristics, such as cost structure, similar or superior to those being analyzed.”
It should also be said that robo-advice is not always completely digital. Several firms such as Fidelity Investments, Vanguard and Financial Engines combine their robo-advice offerings with human components in order to provide plan participants with digital access to their investments as well as access to a human voice.