The Securities Litigation Expert Blog

The DOL Fiduciary Rule - Risk Tolerance Questionnaires

Posted by Jack Duval

Aug 2, 2017 7:31:02 AM

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This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

In my last blog post, I discussed how the traditional three-choice Investment Objective and Risk Tolerance options would no longer be sufficient under the DOL FR.  In this post, I will expand on topic of Investment Policy Statements (“IPS”) and an often-missed aspect of their drafting – determining both the client’s ability and willingness to take risk.

The Difference Between the Ability and Willingness to Take Risk

Most financial plans focus on the client’s ability to take risk.  This is usually accomplished mathematically, by predicting cash flows and evaluating those against known liabilities.  Generally, the thinking is if the client can sustain losses and still meet her needs, then she has the ability to take risk.  (For instance, if the client needs $20,000 per month to sustain her lifestyle, but her portfolio can generate $40,000 per month, after fees and taxes, then she has a high ability to take risk.) 

The client’s willingness to take risk is a softer metric that requires getting to know the client and their history, going through questionnaires, and scenario planning.  Many of the questionnaires and scenario plans revolve around a series of questions, hypothetical situations, and attempt to determine the client’s probable responses to market events.  For instance: what would you do it your portfolio declined by 10, 20, or 30 percent?

Problems with Risk Tolerance Questionnaires

In my experience, most risk tolerance questionnaires lead to inflated risk tolerances.  The reason is that unless the most conservative answer is given to every question, the client will be scored with a moderate or moderate-aggressive risk tolerance.  Furthermore, if even one question is answered with the most aggressive option, the client will typically end up with a moderate-aggressive or aggressive risk tolerance.

Another flaw in risk tolerance questionnaire design is that they are generic and rely on percentage gains and declines in their examples.  Percentage losses don’t live for clients, but dollar losses do.  For instance, many clients can be philosophical about a 30 percent decline in their portfolio, but most would not be as sanguine about a $3 million decline on a $10 million portfolio.

These flaws can have far-reaching implications.  The skewing towards aggressive Risk Tolerances can lead to misaligned asset allocations, unsuitable investments, and higher than expected volatility.  This frequently leads to clients changing their Risk Tolerance (to what it should have been originally) after a market decline.

Ironically, if litigation should ensue from misaligned asset allocations originating from skewed Risk Tolerances, the questionnaires underlying the improper allocations will be presented as proof of the client’s willingness to take risk, and used to justify aggressive and/or speculative investments.

The Prudent Expert and Risk Tolerance

For background on the Prudent Expert Standard required under the Best Interest Contract Exemption, see my previous posts here and here.

Simplistic, one-dimensional Risk Tolerance Questionnaires will not meet the Prudent Expert Standard.  Instead, the due diligence required to "know the client" is at least a two-dimensional approach to risk tolerance that encompasses both the ability and willingness to take risk.

If only one type of Risk Tolerance is identified, the advisor cannot make a Prudent Expert determination of the client’s true Risk Tolerance.  This will not meet the fiduciary standard, nor even the suitability standard.

One of the few financial writers to address the two dimensions of Risk Tolerance is Michael Kitces.  Some of his writings on risk tolerance can be found here, here, and here.  Kitces has created some very useful charts comparing Risk Tolerances that arise from the one- and two-dimensional Risk Tolerance methodologies.

Chart 1:  One- and Two-Dimensional Risk Tolerance Methodologies[1] 

Accelerant - Risk Tolerance - The Ability and Willingness to Take Risk.png

The central idea illustrated in these charts is that in the one-dimensional methodology (left pane), both the ability and willingness to take risk act as a floor to the resulting Risk Tolerance.  Conversely, in the two-dimensional Risk Tolerance methodology (right pane), both the ability and willingness to take risk act as a ceiling to the resulting Risk Tolerance. 

Unpacking One- and Two-Dimensional Risk Tolerance

In the one-dimensional Risk Tolerance methodology, both the ability and willingness to take risk increase Risk Tolerance.  Thus, if the client has either a high ability or high willingness to take risk, she will end up with an aggressive Risk Tolerance.  However, this is the perverse Risk Tolerance outcome discussed above.

Under the one-dimensional Risk Tolerance methodology, a low ability to take risk is overridden by a high willingness to take risk, at the same time a low willingness to take risk is overridden by a high ability to take risk. 

However, under the two-dimensional Risk Tolerance methodology, this cannot happen because both the ability and willingness to take risk decrease Risk Tolerance.  Thus, if the client has either a low ability or low willingness to take risk, she will end up with a conservative Risk Tolerance.

Under the two-dimensional Risk Tolerance methodology, a high ability to take risk is overridden by a low willingness to take risk, at the same time a high willingness to take risk is overridden by a low ability to take risk.

The two-dimensional Risk Tolerance methodology results in much more accurate Risk Tolerances and helps implement a financial advisor’s version of the Hippocratic Oath: help clients achieve their goals with the least amount of risk possible.



[1]       Michael Kitces; Nerd’s Eye View; Adopting a Two-Dimensional Risk Tolerance Assessment Process; January 25, 2017.  Available at:; Accessed August 1, 2017.


Click to view useful links on our DOL Fiduciary Rule - Securities Litigation Resources page.

To learn more about fiduciary expert Jack Duval, click here.


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Topics: risk tolerance, litigation, suitability, Due Diligence, securities litigation, Investment Policy Statement, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule, prudent expert standard

The DOL Fiduciary Rule - Investment Policy Statements

Posted by Jack Duval

Jul 26, 2017 9:07:10 AM

DOL - Accelerant Fiduciary Rule Expert.jpeg

This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

One of the implications of a fiduciary standard is that investment recommendations will be judged on an ex ante basis.  Ex ante is a Latin phrase common to law and economics that loosely translates to “before the event”.

This means that fiduciary recommendations must meet the Prudent Expert Standard before the recommendation is made.  While this may seem logical and obvious, it carries important implications should litigation arise from the fiduciary advice.

As discussed in my previous post, there are specific duties of due diligence that arise from the DOL Fiduciary Rule (“DOL FR”) for both the firm and the advisor.  In this post, I will focus on one aspect of diligence that should be made and documented, ex ante, in order for a fiduciary recommendation to be made: the Investment Policy Statement (“IPS”).

Investment Objective and Risk Tolerance

Industry standard broker-dealer (“BD”) new account forms have three choices of Investment Objective:[1] 

  • Income;
  • Total Return, and;
  • Growth;

and three choices of Risk Tolerance: 

  • Conservative;
  • Moderate, and;
  • Aggressive.

These traditional Investment Objective and Risk Tolerance choices are vague and generic.  They are also subject to abuse.  In my experience, most clients end up with a Total Return/Moderate or Growth/Moderate Investment Objective/Risk Tolerance.  If litigation arises, these combinations are used to justify virtually any asset allocation or investment strategy.

Furthermore, I have frequently encountered new account forms where multiple Investment Objectives and/or multiple Risk Tolerances will be selected.  This practice renders the new account form useless and the account non-supervisable.  For instance, if the Risk Tolerances: Conservative, Moderate, and Aggressive are all selected, then any type of investment will comport with them, including all cash and all equities.

Under the DOL FR, these short-hand categories will no longer be sufficient.  While they could still be used to provide a supervisor an at-a-glance summary when doing a first-level review, they are too vague and generic for the advisor to demonstrate knowledge of their client at a fiduciary level or to manage the investments appropriately.  They are insufficient for supervision as well.

The industry standard for fiduciaries is to have an Investment Policy Statement.

Investment Policy Statement

An investment policy statement is described by the CFA Institute as:[2]

A strategic guide to the planning and implementation of an investment program… 

The IPS is a highly customized document that is uniquely tailored to the preferences, attitudes, and situation of each investor.  Templates that purport to offer convenience and ease in development of an IPS almost inevitably sacrifice consideration of factors that are highly relevant to the investor.  The investment professional must thoroughly understand the investor’s objectives, restrictions, tolerances, and preferences to be able to develop a truly useful policy guide.  (Emphasis added)

An IPS is important for the successful planning, implementation, and ongoing management of investments over time.  The CFA Institute’s description of the benefits of an IPS includes:[3]

When implemented successfully, the IPS anticipates issues related to governance of the investment program, planning for appropriate asset allocation, implementing an investment program with internal and/or external managers, monitoring the results, risk management, and appropriate reporting.  The IPS also establishes accountability for the various entities that may work on behalf of an investor.  Perhaps most importantly, the IPS serves as a policy guide that can offer an objective course of action to be followed during periods of market disruption when emotional or instinctive responses might otherwise motivate less prudent actions.  (Emphasis added)

As a “highly customized document”, the IPS goes well beyond the check-the-box Investment Objective/Risk Tolerance that is frequently used today.  As an example, instead of a check-box that would allow “Speculative” investments, an IPS would define the exposure as a percentage of the portfolio, i.e. 3 percent, etc.  This policy could then be used to guide implementation, and if litigation were to arise, the investments could be evaluated for comportment with the IPS.

Although not required by the DOL, an IPS is contemplated under the DOL FR. 

The Department of Labor is well aware of the benefits of IPS’ and speaks directly to their requirement under ERISA:[4]

This interpretive bulletin sets forth the Deportment of Labor’s interpretation of sections 402, 403, and 404 of the Employee Retirement Income Security Act of 1974 (ERISA) as those sections apply to voting of proxies on securities held in employee benefit plan investment portfolios and the maintenance of and compliance with statements of investment policy

The maintenance by an employee benefit plan of a statement of investment policy designed to further the purposes of the plan and its funding policy is consistent with the fiduciary obligations set forth in ERISA § 404(a)(1)(A) and (B)...

For purposes of this document, the term “statement of investment policy” means a written statement that provides the fiduciaries who are responsible for plan investments with guidelines or general instructions concerning various types or categories of investment management decisions…

Statements of investment policy issued by a named fiduciary authorized to appoint investment managers would be part of the “documents and instruments governing the plan” within the meaning of ERISA § 404(a)(1)(D). (Emphasis added)

Without an IPS the client’s investments are untethered from predetermined guidelines, unaccountable for performance, and more subject to emotional management and behavioral biases.

It is very difficult to see how an ERISA fiduciary could meet the prudent expert standard without having an IPS.

No Safe Harbor

Importantly, a fiduciary advisor cannot craft an IPS that is inappropriate for the investor and then use that as a safe harbor from the fiduciary standard.  The DOL writes:[5]

… ERISA § 404(a)(1)(D) does not shield the investment manager from liability for imprudent actions taken in compliance with a statement of investment policy.

As I’ve discussed in previous blog posts, the Prudent Expert Standard is extremely rigorous and applies to the crafting of an IPS as well as investment recommendations and implementation.

If an IPS is defective, abusive, or inconsistent with the client’s particular facts and circumstances, goals and objectives, it will violate the fiduciary standard.



[1]       Through my securities litigation consulting work, I have seen new account forms from well over 75 different firms, including small, regional, and global BDs.  Some new account forms will also have a check box to select if “Speculative” investments are allowed.

[2]       Elements of an Investment Policy Statement for Individual Investors; CFA Institute; May 2010; 1.  Available at:; Accessed July 25, 2017.

[3]       Id.

[4]       29 CFR Ch. XXV (7.1.07 Edition); § 2509.94-2; Interpretive bulletin relating to written statement of investment policy, including proxy voting policy or guidelines; 364-6.

[5]       Id. at 366.

Click to view useful links on our DOL Fiduciary Rule - Securities Litigation Resources page.

To learn more about fiduciary expert Jack Duval, click here.


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Topics: litigation, Due Diligence, securities litigation, Investment Policy Statement, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule, prudent expert standard

Len Santoro, Fixed Income Expert, Joins Accelerant

Posted by Jack Duval

Oct 27, 2014 1:47:50 PM

Accelerant is excited to announce that Len Santoro wil be joining the firm as a consultant.  Len is the former CIO of Prudential's pension fund business.  He will be joining us to consult and provide expert testimony on fixed income, mutual funds, institutional asset management, and pension related areas.


A Q&A with Len is transcribed below:

Brendan Reese for Accelerant:  Describe your professional background?

Len Santoro:  The bulk of my investment management experience was at the Prudential.  I was hired directly out of Columbia Business School to manage the Pru-Bache mutual funds and a pension fund for the Western Conference of Teamsters.  A few years later I was part of a team that was formed to increase Prudential's presence in the pension fund management business. I eventually became the CIO of this unit which at its peak had assets under management in excess of $27 billion and a staff of 27 investment professionals. 

Reese: What kind of fixed income did you deal with?

Santoro: We were a global manager. Given that, about 75% was in the investment grade US market. The rest was in High Yield, Emerging Market and non-US government debt.

Reese:  How closely did you work with your pension clients in drafting their Investment Policy Statements?

Santoro: That really depended on the client.  Some were quite sophisticated and provided detailed investment objectives and guidelines.  I'm not talking just about sector and quality Limits but guidelines that included the duration range around specific market sectors and even coupon distribution in the mortgage sector.

Other clients needed more guidance.  In many cases proposed guidelines were included in the original RFP and were intended to link risk and reward.  Exploring the potential risks associated with large duration, sector and quality bets were key elements in establishing the guidelines and objectives of the portfolio.  

Reese:  How frequently did you see pensions change their IPS and what would be a typical impetus for that.  Also, what kind of issues would that raise from the asset management perspective?

Santoro: I recall a few instances when clients change both the portfolio objective and it's benchmark.  Both clients were very sophisticated.  In one case I remember getting a call at 11 o'clock in the morning and it was changed by the end of the day.  In another case, weeks of discussion preceded the change.

In another instance I recall an investment opportunity being presented that was not specifically permitted in our guidelines.  I reached out to the client and if I remember correctly within a month a change to the guidelines had been approved.

In most cases though, changes occurred due to some event that caused a violation of the guideline. I remember back in the 1990s when one of the automobile credit companies was surprisingly downgraded to junk.  Suddenly the market was being flooded with the paper because so many investment-grade portfolios had the same restriction of no junk.  We went to our clients looking for 6 month relief to let the selling pressures ease.  Again, it was a relatively easy process and our request was approved.

It is Important to remember that in many cases the guidelines evolve as situations change.  For example, assume the guidelines say that nosecurities shall be purchased with a non-investment grade rating. Does that mean that a bond purchased with a triple B rating and is later downgraded to below investment grade needs to be sold?  Clearly a conversation needs to be had between the client and the manager. Same type of example applies to maximum positions in individual securities or sectors.  I recall in some situations where a maximum sector position at purchase was set at 25% but in no case would exceed 30% as a result of changes in market value.  In this case both the client and the manager knew exactly how the portfolio should be positioned and what actions would be taken.

Reese: Tell me about the world of Taft Hartley asset management? What is it and how does it work? How is it different?

Santoro: A Taft Hartley pension plan involves a group of employers and one Union.  In my experience the plan is run by a Board consisting of an equal number of employer and union representatives. 

The pension is the result of a collective bargaining agreement. In managing assets there is absolutely no difference between a Taft Hartley and a single employer sponsored plan. The objective, guidelines, and benchmarks are all very similar.

The biggest difference can be with client service and reporting if the manager is required to meet with the entire board. In some cases, however, the plan uses an Investment Advisor that fills a role that the chief pension officer would have at a single employer sponsored plan.  In that case there is absolutely no difference (between their roles).

Reese: Throughout your long career watching the fixed income markets, what month or time period comes to mind as particularly interesting and exciting?

Santoro: I think the Paul Volker era was one of the most interesting periods.  The vice he put on the money supply to break the back of very high inflation was unprecedented and controversial.  Heck even in 1981 there was still doubt that he would be successful.  It was in that year the U.S. Treasury needed to put a 14% coupon on a 30 year bond!  His success has been well documented.

October 1987 was another interesting period. Those of us long enough in the tooth recall the stock market plunge, but little noticed the volatility in the bond market.  The long bond which normally traded with a bid/ask spread of a "32nd" ( a "32nd" amounting to $312.50 on a million dollar bond) suddenly traded at 2 or 3 point spreads ( a point being $10,000 on a million dollar bond).  This presented difficult problems for us since we had clients looking to add in excess of a billion US dollars to their bond portfolio.

The demise of Drexel was interesting in that it put counter-party risk back on the front burner which I am sure was was nothing compared to the chaos of Bear, Lehman and the 2008 crisis.


Reese:  What are some interesting developments you've seen in the bond market recently?

Santoro: These bank "CoCo" bonds are pretty interesting.  The CoCo stands for contingent convertible and are being issued as a safety net for the banks to maintain minimum capital levels under the Basel agreement. They are either converted into stock or written down entirely if the banks capital level reaches a certain trigger point.

The bond can never be converted to stock at the option of the bond holder.  In some cases if the trigger, defined  in each deal as somewhere between a 4% and 8% capital ratio, is breached the issuer can convert the bonds to stock or in some cases write down the value of the bond entirely.  

Some of the early research indicated that the market for these bonds was the retail investor.  That is clearly not appropriate.  The securities and the risk associated with them are way too complicated for a naïve investor.  In fact I believe the UK has banned sales to the individual market.  In addition I saw a recent HSBC deal that establish minimum lots of $200,000 which in effect minimizes retail participation.

Reese: What are some of your other interests?

Santoro: I love the markets, Italian cooking and my 2 Labrador retrievers. 




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Topics: fixed income experts, Contingent Convertible Bond, Taft-Hartley, Pension Management, Investment Policy Statement, Len Santoro

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