Death Care Law Blog : Kansas Death Care and Preneed Lawyer & Attorney : Stalter Legal Services Law Firm : Funeral Law, Elder Law : Kansas City

I stand corrected.

A representative of the Michigan Funeral Directors Association advises that their request for proposal for a new investment advisor for the master trust has resulted in the selection of a firm that will not only assume a true fiduciary relationship to funeral directors and consumers, but that will also guide the Association towards a target date investment strategy. Such an investment strategy would represent a true demarcation from the approach I was so critical of in a March post about the Michigan RFP.

Too often, the fiduciary's approach to preneed investment has been to offer three investment options to the funeral director. The fiduciary may even allow the funeral director to choose an asset allocation among the investment options. Little regard is given to the experience and sophistication the funeral director possesses with regard to financial and investment considerations. While Michigan law imposes a separate investment standard on non-guaranteed contracts, that is not the case in most states. Consequently, the two types of contracts are typically pooled in the same trust, and invested similarly. This presents a problem for the funeral directors that either take chances with the market or are ultra conservative. Another flawed investment approach is to allow income reporting to be the exclusive consideration.

Corporate fiduciaries have struggled with the delegation of investment responsibilities of the preneed trust. The uniform trust code contemplates the delegation of the investment responsibilities, and may even require such when the fiduciary lacks the expertise to properly invest the trust. But, it is virtually impossible to transfer the liability of that delegation. Applicable statutes contemplate notice and consent of the trust beneficiaries. The investment risk lies with the consumer who has purchased a non-guaranteed contract. With guaranteed contracts, the investment risk is assumed primarily by the funeral director. However, that risk is shifted to the consumer if the contract is 're-written' when the purchaser's survivors select a different arrangement at the time of need. The investment risk is also transferred when the funeral home goes out of business and the preneed contracts are not assumed by a successor entity.

Depending upon the factors incorporated by the investment strategy, the target date plan can provide a better model for the death care industry.

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If you haven’t noticed, there has been some turnover among the associations’ preneed fund managers. With the threat of additional litigation in Wisconsin, this trend could continue. But not all of the turnover has been as publicized as what we have seen in Illinois and Wisconsin. After 20 years at the helm, Merrill Lynch recently gave notice to the Michigan Funeral Directors Association of its resignation. There are no search protocols for preneed fund managers, and so Michigan borrowed from the retirement fund community by publishing a request for proposal (RFP). While the MFDA should be commended in their effort to bring transparency to their program’s asset management, they missed (or ignored) an opportunity to shift more investment responsibilities to the financial industry. Instead of using FINRA Rule 2111 (“know your client”) to their advantage, the MFDA structured the RFP to perpetuate (and extend) the funeral director’s controlling role in investment decisions.

Hidden investment charges have been ‘part of business’ in the death care industry for decades, and this author has contemplated whether ERISA’s fee disclosure requirements could ever be incorporated into preneed trusts by the Federal Trade Commission. The Michigan RFP focused on the same ERISA fee disclosure requirements, which could lead one to assume that association’s leaders did not want to make the same mistake again. The Michigan RFP also raised another ERISA concept worthy of the preneed industry’s consideration: the 401K approach to investment by individual contract. We too have wondered why larger programs have not looked at data from individual contracts and the sponsoring funeral homes to build an investment options matrix.

But, the Michigan RFP can be faulted for cutting off the diligence requirements of FINRA Rule 2111. To insulate the Association from solicitations, the RFP provided summary information about the program and required all inquiries to go through an ERISA consultant. Prospective fund managers were required to submit investment strategies on limited facts and without direct communications to the Association. It is understandable that the Association would want to narrow the field before initiating an exchange of confidential information with prospective managers, but the screening of candidates should have preceded the request for investment strategies. Subsequent to the screening, the MFDA should then have provided detailed information pursuant to a confidentiality agreement. Under FINRA 2111, this sequence would have expanded the fund manager’s diligence responsibilities regarding investment strategy recommendations. The nature of the questions posed by the candidates would also have helped the MFDA in its assessment of the candidates. Instead, the RFP narrowed the fund manager’s diligence to an old investment strategy with a history of mixed results and challenges.

Within the context of ERISA retirement funds, RFPs may take a formula approach to finding a replacement fund manager. But the preneed industry is fragmented by 50 different state laws, and by program issues such as whether non-guaranteed contracts are sold, the association’s role as a seller versus an agent, investment restrictions, and trusting percentages. Injecting preneed asset management with a dose of ERISA could help to discourage hidden fees and improve the quality of fund managers, but the industry also needs an alternative to the strategy of offering funeral directors three investment options to choose from.
 

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Both the Memorial Business Journal and the Funeral Service Insider commented last week on the Milwaukee Journal Sentinel’s February 7th article regarding the former executive director of the Wisconsin Funeral Directors Association. Several issues were raised that should be included in future industry debate, and in particular, I would agree with Mr. Isard’s questions whether association executives are qualified to manage a master trust. But the following comments beg an immediate response:

“The whole situation with [the] Wisconsin Preneed Trust went off the rails when the goal shifted from trusting funds to investing funds.”

“The assumption that these trust funds are in the investment business is a mistake. We’re not. We’re in the trust business. From my view, that is a presumption of a preservation of principle. With a trust, you have an obligation to be prudent.”

Those comments suggest that trusting funds and investing funds are somehow mutually exclusive. While the comments may reflect the views of much of the death care industry, they also reflect a failure to understand the fiduciary’s duties. When entrusted with the money of another, the fiduciary has a duty to invest those funds consistent with the purposes of the trust and the interests of the trust beneficiaries. The fiduciary’s investment duties are governed by other laws, and a majority of our states have adopted the Prudent Investor Act. Wikipedia provides the following explanation of that Act:

In enacting the Uniform Prudent Investor Act, states should have repealed legal list statutes, which specified permissible investments types. (However, guardianship and conservatorship accounts generally remain limited by specific state law.) In those states which adopted part or all of the Uniform Prudent Investor Act, investments must be chosen based on their suitability for each account's beneficiaries or, as appropriate, the customer. Although specific criteria for determining "suitability" does not exist, it is generally acknowledged, that the following items should be considered as they pertain to account beneficiaries:

• financial situation;
• current investment portfolio;
• need for income;
• tax status and bracket;
• investment objective; and
• risk tolerance.

The majority of preneed trusts involve a single seller/provider and guaranteed preneed contracts. Under such circumstances, the funeral home operator has assumed the investment risk when the preneed contract is performed as written. Fiduciaries (and fund managers) have viewed the operator as the account beneficiary for purposes of the Prudent Investor Act. But depending upon state law, and whether the contract is ‘re-written’ at the time of death, the preneed purchaser may bear the investment risk. Accordingly, the fiduciary and fund manager should not completely ignore the preneed purchaser as the account beneficiary for purposes of the Prudent Investor Act.

Neither fiduciaries nor fund managers want to bring the preneed purchaser into the Prudent Investor equation for obvious reasons. But are suitability of investments for two that dissimilar? We would suggest not if the objective is to have investment performance track the prearrangement’s purchase price increases. As we noted in a March 2010 post about the IFDA master trust, the purchaser of a non-guaranteed contract was unhappy because the return on her non-guaranteed contract (1.7%) did not keep pace with the price increases of her planned funeral (4.2%).

Determining who to include as an account beneficiary in the Prudent Investor equation only gets more complicated when the preneed trust is an association master trust with dozens, or hundreds, of funeral home operators. If the master trust includes a healthy percentage of non-guaranteed contracts, the number of account beneficiaries could swell to the thousands. If the association is not the preneed seller (as is the case in Missouri, but not Illinois), what interest does the association have in the trust so as to justify being considered an account beneficiary? There are arguments in support of the association being such a beneficiary, but can those interests ever outweigh the funeral operator and the non-guaranteed contract purchaser?

One could argue that the Wisconsin Master Trust was never fully on the rails. The Association determined early on that a depository account could not keep up with rising funeral costs. Rather than seek legislation that would clarify the trust’s investment authority, the Association leadership sought regulatory permission to allow the master trust to embark on the path of investment diversification. The program derailed only after the executive director enmeshed his personal objectives with those of the association and then conspired with the fund managers to treat the association as the master trust’s primary account beneficiary.
 

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In the days that followed the Wisconsin Funeral Directors Association being placed into receivership, some of the WFDA’s sister associations were quick to point out they had ‘checks and balances’ that would protect consumers’ funds from the problems that tripped up the Wisconsin Funeral Trust. As we reported in our last post, a crucial ‘check and balance’ missing from the WFT was investment oversight. The fact that a trust has a corporate trustee does not necessarily mean that fiduciary has responsibility for monitoring the prudence of the investments. Corporate fiduciaries often look to uniform trust codes for the authority to delegate investment responsibilities. If a grantor wishes to use an outside asset manager, general trust laws will accommodate those wishes. The problem with preneed trusts (and cemetery endowment funds) is that there is more than one “grantor” to the preneed trust.

We have previously stated our support for allowing a relationship between preneed seller and a qualified fund manager. However, the fiduciary must provide a ‘check and balance’ to that relationship by maintaining responsibility for the investments. The ‘scandals’ from Missouri, Illinois, California and Wisconsin stem from a lack of investment oversight. Missouri’s regulators responded to NPS with a law that precluded any relationship between the advisor and the seller. Appropriately, the Missouri association obtained revisions to allow an agency relationship between its fund manager and the trustee. However, the Missouri law does not go far enough to require the disclosures we recommended in 2011. Funeral directors and consumers need to know that Missouri preneed fiduciaries ‘have their back’ when it comes to investment oversight.

Investment oversight is also a concern for cemetery regulators. Kansas’ cemetery regulators were dismayed to find that a corporate trustee had turned over the investment reigns to a Hutchinson cemetery operator. The operator hoped to cover declining revenues (and the failure to make trust deposits) with higher investment returns. For months, the operator attempted to hide the ball from the auditor, but eventually it was discovered that those investments had lost hundreds of thousands of dollars.

The investment supervision issue is also a concern for Nebraska regulators. As they prep the death care industry for legislation in 2013, they raise this issue:

Seller’s Power to Direct Investments

A question has arisen regarding the seller’s ability to direct the trustee’s investment decisions. Specifically, should the seller be able to instruct the trustee to deposit or invest funds in securities that do not meet the trustee’s own investment guidelines?

If it is determined that the trustee should be free from the seller’s investment influence, section 12-1107 should be amended to reflect this fact.
 

In what may be a perfectly legal arrangement, Illinois funeral directors have handed off investment oversight to their new fund managers. The master trust instrument carefully outlines the code provisions which authorize the delegation of investment authorities. But the document goes that extra step of exculpating the trustee from responsibilities for investment oversight. Where is the check and balance in that structure? Are the industry’s expectations so high that a trustee will not accept the fund without a hold harmless? If the industry does not establish its own ‘checks and balances’ with regard to investment supervision, the authority to participate in the investment decisions could be taken away.
 

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Many state preneed regulators share the point of view that the payments made toward a preneed contract belong to the consumer until the prearranged funeral is provided. This perspective was adopted by the California Attorney General in its Eighth Cause of Action brought against the California Funeral Directors Association and its Master Trust. The AG criticizes the CFDA for investment decisions that are fairly representative of those taken by the industry as a whole.

Early on, the CMT relied upon bond funds that specialized in zero coupon government bonds. The AG points out that U.S. Treasury Bonds and similar bond funds outperformed the CMT at less risk and with lower fees.

When the bond market crashed in 2001, the CMT experienced substantial investment losses and changed investment course. The CMT began diversifying, and purchasing mortgaged back securities, foreign bonds and notes, corporate asset-backed securities and other types of securities. The AG criticizes these investments by stating “these types of investments are not insured bank accounts, are not bonds that are legal investments for commercial bank (sections 1001 et seq. of the Financial Code lists certain legal investments for commercial banks), are not government bonds, and do not comply with the Uniform Prudent Investor Act (as discussed below).”

The AG goes on to argue that the investment policies of the CMT should be set by the risk and return objectives of the preneed contract beneficiaries, and faults the defendants for having set investment policies based on their own needs.

Other states’ preneed regulators (and cemetery regulators) share the California AG’s point of view. It is common to hear a regulator characterize the preneed trust as a depository account or to express the belief the industry would be better off if preneed funding were left to the insurance companies. These regulators need to take the blinders off.

The CMT, like so many preneed trusts, went into tax exempt investments after 1988 because of Revenue Rul. 87-127. The Internal Revenue Service pushed for an income reporting method that proved impractical and burdensome. To compound the situation, the IRS applied the ruling retroactively to certain states. California was one of those states. Prior to the ruling, funeral homes had no reason to require the consumer’s social security number when selling a preneed contract. Consequently, many California trustees could not comply with the ruling with regard to existing contracts.

The ruling required grantor statements to be sent to consumers, and the consumers complained. So, funeral homes instructed their preneed fiduciaries to go into anything that didn’t require a grantor statement. While the CMT went to zero coupon bonds, the IFDA went into the poorly conceived key man insurance. Other trusts went into annuities. Various approaches were taken because the IRS could not provide reporting guidance once it changed the rules.

In stating that the preneed funds must be invested pursuant to the contract beneficiary’s objectives, the California AG has ignored the fact that a majority of these preneed contracts are probably guaranteed. Under that arrangement, the funeral home has assumed the investment risk. From a practical approach, how would the investment advisor determine the objectives of the thousands of preneed beneficiaries? In a prior post, this blog reported about an Illinois contract beneficiary’s complaint about the IFDA Master Trust. In contrast to the losses suffered by the member funeral homes, the beneficiary experienced a modest return on her non-guaranteed contract. Her complaint was that the return was not enough to keep up with rising funeral costs.

The California AG argument that the CMT must comply with the Prudent Investor Rule in a way that does not expose trust principal to risk is the equivalent to handcuffing both of the investment advisor’s hands behind his back.

Of the investment complaints made by the California AG, the one which would seem to merit the most attention would be the relationship between the former investment advisor and a CFDA board member. That CFDA board member also served as a trustee for one of the advisor’s funds, for which he received compensation. That relationship warrants an inquiry whether the relationship was disclosed and the compensation appropriate and reasonable.

The AG’s argument that the investment advisor must be independent from the seller is one shared by Missouri regulators. The Missouri regulators are quick to point to the abuses committed by NPS and its investment management firm. (See our post titled “The Zeal for Independence”). Those abuses were so bad that the Missouri legislature passed a provision prohibiting a relationship between the seller and the fund manager. This author thought the provision went too far. (See our post titled “Regulating Out of Context”). With the passage of SB 325, the Missouri Funeral Directors Association has convinced the Missouri legislature that it did go too far.

Regardless of whether the fund manager is a fiduciary employee or an independent investment advisor, that fund manager should appropriately look to the preneed seller for input about investment objectives. For the larger trust, the fiduciary and fund manager should adopt a written investment policy that, among other factors, considers the trust’s mix of guaranteed and non-guaranteed contracts. If the fund manager is an independent investment advisor, the relationship should be documented with an agreement that discloses all forms of compensation. Consistent with the SEC efforts to reform mutual funds, the disclosure should address any 12b-1 fees. The agreement with the fiduciary should also disclose all relationships the investment advisor has with the preneed seller.

To the extent the preneed contract is guaranteed, the regulator needs to recognize the seller’s economic interest in the trust’s performance. But, fiduciaries and sellers need to consider the growing number of non-guaranteed contracts and the possibility that the guaranteed contract may be serviced by a different funeral home. While the seller may have the prevailing economic interest, not all of the trust may be considered his for investment purposes.

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Over the next year, Missouri will examine the various flaws of SB1. One of those flaws concerns the independent investment advisor and the ‘fix’ meant to preclude conflicts of interest.

Preneed trusts have a poor track record in terms of investment performance. Trustees often fail to appreciate the key factors that impact investment strategies for preneed. Those factors can vary substantially from trust to trust, making the fund manager’s job more difficult.

Consequently, it is not uncommon to see large trusts delegate investment authority to an independent fund manager. Missouri’s old preneed law took the practice an ill-advised step too far by relieving the trustee of liability for the advisor’s decisions. NPS exploited that provision by appointing investment advisors who handed the keys to the vault to Lincoln Memorial. Believing themselves to be exculpated from investment liabilities, the NPS fiduciaries became bystanders to the largest preneed fraud in history.

Section 436.445 of SB1 appropriately requires the fiduciary to remain responsible for the investment advisor’s actions. However, the statute goes too far in attempting to preclude any relationship between the advisor and the seller. The provision was lifted from Missouri’s Uniform Trust Code without adequate consideration of the relationships of the seller, fiduciary and fund manager.

In contrast to SB1, the Uniform Trust Code does not prohibit relations between the trustor/seller and the investment advisor (or any service provider to the trust). Missouri’s preneed industry would be better served if such relations were allowed if fully disclosed and subjected to a higher level of scrutiny.
 

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