Seven deadly habits: CPAs serving as fiduciaries must avoid common investment pitfalls.

Many CPAs have clients who serve as fiduciaries, and recently we, as CPAs, have started serving as fiduciaries ourselves. Given the growing reliance on CPAs--as financial complexity and personal liability increases--that trend is likely to continue.

But the path to fiduciary success is fraught with challenges and those serving in this role for the first time may find themselves overwhelmed.

So, how can we increase the performance and lessen the liability of this role? Simply by avoiding the bad habits that so often plague investors.

The following is an overview of seven bad habits to avoid when serving as a successful fiduciary:

No. 1: Failure to understand financial/regulatory environment

Flooded daily with financial news and information, it's difficult to believe we don't have sufficient information to make informed decisions about money. Yet, it is getting harder to sift the wheat from the chaff and grab the information we need.

Properly prepared fiduciaries must be intelligent consumers of news and trends, and must ask challenging questions, especially when reviewing vendor marketing materials:

* What are historical factors we must know to better evaluate vendor sales pitches?

* Under what rules will we make and document our decisions?

* How do we ask the right questions to fulfill our duty to oversee those investing our money?

Getting good answers does not guarantee future returns, but can help frame probabilities as to what returns are likely--or unlikely. One way to evaluate a vendor is to ask if that vendor understands these questions and why they must be asked. The financial--and regulatory--environment helps explain why those questions must be asked.

First, a fiduciary must understand the risk/reward tradeoffs when weighing likely portfolio returns and evaluating recommendations for asset allocation. And second, depending on the investor, different rules apply, such as those imposed by ERISA; Uniform Management of Institutional Funds Act; and Uniform Prudent Investor Act. The latter is the most broadly applicable to the individual investor.

No. 2: Failure to focus on liabilities

For most investors, assets are accumulated to generate income, either for today or tomorrow, or both. Pension funds see benefit payments as a liability, and endowments see them as formal spending policies, though with greater flexibility. Individuals and families need to focus on the cash flow generating capacity of the assets.

So, why is this important?

First, payment streams affect principal balances in ways that are not intuitive. Suppose a portfolio is expected to earn 8 percent. You should expect to withdraw 6 percent each year, for example, without risk to principal. But history tells us we should expect to withdraw between 3.5 percent and 4 percent without risking asset depletion over a 15 to 20-year period.

The mathematics used to determine liabilities is different from that used to determine asset allocation. It could be that an optimal mix, considering liabilities and risk tolerance, will be different than a pure asset-mix and offer lower risk to the investor.

No. 3: Failure to adopt a real investment policy

Most pools of capital managed by committees are subject to an oversight document or investment policy. Fiduciaries are aware that this document should be used to measure compliance and performance.

Our experience has been that many documents aren't followed. Occasionally, the policy gets reviewed when a new committee member comes on the committee or when someone asks if the committee has an investment policy. But the committee rarely reviews the policy when members are deciding a course of action, measuring results or holding managers accountable.

Investors, and committee members, are human. Humans make mistakes in the way they perceive information and make decisions. Institutional investors understand this and install systems to avoid screwing up under pressure.

No. 4: It's easy to pick money managers

We know past performance does not guarantee future returns. But behavioral economists have identified one major quirk about how we view this statement--many of us believe that we can find patterns to exploit and beat the odds.

Pigeons and rats test better at investing--following probabilities in a more disciplined fashion. We as humans try to game--and beat--the system. We keep trying to do so no matter how unsuccessful we are at it.

Institutional investors know better. They know that it's difficult to find good managers and difficult to maintain the discipline crucial for success, and they know that diversification is key to profitable long-term performance.

No. 5: Paying lip service to rebalancing 

Rebalancing is the process of restoring a portfolio's asset allocation after one or more asset classes do particularly well--or poorly. It is easy to agree that this discipline is valuable in committee meetings focused on strategic planning, but much more difficult to get agreement when time to implement.

Rebalancing only works when it hurts. Who wants to reduce a portfolio's stake in technology stocks, for example, when it's doing well? Restoring the allocation is the only way to control risk, and doing so can translate into better returns for the long run.

No. 6: Focusing too little on expenses

We know that high expenses cause a drag on performance. But what is "too high?" A fiduciary must go beyond fee comparisons to better understand costs, especially when comparing providers.

Often, focus is on management fees, but studies show that turnover costs, mostly high execution costs, creates high fees. Investors should consider what value they receive for the fee they pay.

No. 7: Failure to hold ourselves accountable

How can this be? We have meetings. We hear reports. We look at charts comparing performances to indexes: What more could we do? Plenty.

Reporting should be conducted in the context of a real investment policy. We should ask how the portfolio is doing relative to our risk and return expectations.

What effect will performance have on our ability to make payments or meet liabilities? Are we doing as well as we ought to be doing under current investing conditions?

Fiduciaries must be loyal to their beneficiaries, not their vendors. Yet, we find investors more loyal to vendors, whether because of longstanding friendship or inertia.

Relationships are important, but performance is required of fiduciaries.

So, what does it all mean? If a breakdown happens, it occurs because fiduciaries spend too much time on forecasting or listening to stories about their successful stock investments.

Fiduciaries should ensure that their oversight covers required policy information in an acceptable format; then they can relish the fun stories about those winning stocks later.

Conclusion

With a little understanding, focus, hard work and accountability, CPAs with clients that serve as fiduciaries--or CPAs that serve as one themselves--would do best to avoid these often deadly investment habits.

By Tim Anderson, CPA 

Tim Anderson, CPA, is a principal with Long Beach-based Halbert Hargrove/Russell LLC and chair of CalCPA's Estate Planning Committee. He can be reached at [e-mail] or by visiting www.calcpaweb.orglestate.