Interpreting the DOL’s Amicus Brief and its Potential Impact on the Future of 401(k) Litigation

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

Whenever I meet with a prospective new client, I first explain InvestSense’s “401(k) Fiduciary Prudence Circle,” (FP Circle), one of the cornerstones of our “Fiduciary InvestSense™” process. ERISA and the courts analyze a fiduciary’s decisions in terms of the process used by a plan sponsor in selecting investment options for a plan, not in terms of the ultimate performance of the investment options chosen. The combination of the FP Circle and the Active Management Value Ratio™ (AMVR) provide evidence of both the use of a meaningful process and the compliance of same with applicable legal standards.

We also educate the prospective client on some 401(k)/403(b) fiduciary risk management issues that other consultants usually do not cover. The two AMVR slides below illustrate one of our presentations involving Fidelity Contrafund, a fund found in many defined contribution plans.

The first slide is an AMVR analysis comparing Fidelity Contafund K shares (FCNKX) and the Fidelity Large Cap Growth Fund (FSPGX). Designed to compete with comparable Vanguard funds, FSPGX has done so, both in terms of returns and overall cost efficiency. The issue for plan sponsors is that FSPGX has outperformed FCNKX as well.  FSPGX is clearly a more cost-efficient investment option for fiduciaries than FCNKX.

The problem is that Fidelity does not make FSPGX available to defined contribution plans. As a result, plans seemingly settle for FCNKX, despite the obvious fiduciary liability issues due to FCNKX’s comparative cost-inefficiency when compared to other available investment options.

The slide below is an AMVR analysis comparing Fidelity Contafund K shares (FCNKX) and Vanguard’s Large Cap Growth Index Fund Admiral shares (VIGAX). Plans often use Vanguard’s Admiral shares and institutional shares interchangeably given their similarities in terms of cost and performance.

One again, just as with FSPGX, FCNKX proves to be cost-efficient relative to VIGAX. The cost-inefficiency of FCNKX become even worse when Miller’s Active Expense Ratio is used instead of FCNKX’s nominal cost numbers, as shown in the “AER” column.

The need for plans to address these fiduciary prudence and cost-inefficiency issues has become even more important in light of a recent amicus brief filed by the DOL (DOL brief) addressing the issue of which party has the burden of proof with regard to the issue of causation of damages in 401(k)/403(b) litigation. While there is a split within the federal courts on this issue, the DOL’s brief provides a persuasive argument that the burden of proof belongs to plan sponsors, not plan participants.

One of the most persuasive arguments made in support of this position, both in terms of courts decisions and the DOL’s brief, has been that since the legal focus is necessarily on the process used by a plan in making decisions on the plan’s investment options, such information is exclusively within the possession of the plan. This is why the law has consistently stated that plaintiffs are not required to plead a party’s mental processes or state of mind and why the law allows circumstantial evidence to establish same.

Plan sponsors should take note of and review their plans in light of two statements in the DOL’s brief concerning causation of damages:

In short, [a plan sponsor] would have to prove ‘that a prudent fiduciary would have made the same decision.’

If a plaintiff succeeds in showing that ‘no prudent fiduciary’ would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to ‘shift’ to the fiduciary defendant.

As the AMVR slides herein demonstrate, the AMVR can be easily used to establish the relative cost-inefficiency, and, thus, the relative imprudence of an actively managed mutual fund. As a result, if, as expected, SCOTUS eventually rules that the burden of proof on the issue of causation does “shift” to the plan sponsor, that burden might prove to be a very difficult burden to satisfy in many cases.

For further information on the AMVR, click here.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, evidence based investing, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investments, Mutual funds, pension plans, plan sponsors, prudence, retirement plans, risk management, SCOTUS, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , | Leave a comment

Fiduciary InvestSense™: Annuities, Plan Sponsors, and Fiduciary Law

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

As an attorney and a fiduciary risk management consultant, my job is to protect plan sponsors, trustees, and other investment fiduciaries against unnecessary fiduciary liability…and themselves. Far too often, I find that 401(k) and 403(b) plan sponsors are their own worst enemy. As that great philosopher, Pogo, once said, “we have met the enemy, and he is us.”

I have spent the last 27+ years involved in some way or the other with fiduciary law. The one constant has been the evidence that plan sponsors and other investment fiduciaries do not truly understand what their fiduciary responsibilities do, and do not, require them to do.

As a result, I am often contacted by fiduciaries with questions about fiduciary law, including requests for information on how to extricate themselves from a fiduciary-related legal predicament. As I tell my fiduciary risk management clients, the best strategy for avoiding risk is to avoid it altogether whenever possible. And that is the situation that many plan sponsors are facing with regard to deciding whether to include annuities in their 401(k) and 403(b) plans.

The two fiduciary duties most often cited in 401(k) and 403(b) litigation are the duties of prudence and loyalty

We have explained that the fiduciary duties enumerated in § 404(a)(1) have three components. The first element is a “duty of loyalty” pursuant to which “all decisions regarding an ERISA plan `must be made with an eye single to the interests of the participants and beneficiaries.’” Second, ERISA imposes a “prudent man” obligation, which is “an unwavering duty” to act both “as a prudent person would act in a similar situation” and “with single-minded devotion” to those same plan participants and beneficiaries.1

Finally, an ERISA fiduciary must “`act for the exclusive purpose‘” of providing benefits to plan beneficiaries.2 (emphasis added)

I believe in the KISS philosophy – Keep It Simple & Smart. To that end, I have a simple process that I recommend that plan sponsors use to resolve such matters. I suggest that they ask themselves these two questions:

1. Does ERISA or any other law expressly require that the investment be included in the plan?

2. Would/Could inclusion of the investment in the plan potentially expose the plan and plan sponsor to unnecessary fiduciary liability exposure?

Smart, enlightened plan sponsors will continue to refuse to offer annuities, in any form, within their plans. Why?

  • With regard to annuities and the first question, neither ERISA nor any other law expressly requires plan sponsors to offer annuities or any other any specific type of investment product within a plan.
  • With regard to the second question, neither ERISA nor any other law requires plan sponsors to voluntarily expose themselves to unnecessary fiduciary risk liability. Annuities present genuine fiduciary liability issues, despite the annuity industry’s ongoing refusal to acknowledge and address such issues.

Whenever there is any talk about the enactment of a true fiduciary standard to cover the financial services industry, the industry immediately threatens legal action to block such legislation, with the usual claim of seeking preservation of choice for plan participants. Advocates for a meaningful fiduciary standard typically counter by pointing out that (1) legally imprudent investment products do not constitute a meaningful “choice” for plan participants, and (2) the “choice” argument is, in reality, an attempt to cover up the fact that there are genuine questions as to whether annuities could ever qualify as a prudent investment under a true fiduciary standard. As discussed herein, the evidence suggests that due to the way that they are presently structured, few, if any, annuities could meet a true fiduciary standard

SECURE 2.0 created a “safe-harbor” from liability for plan sponsors who chose to include annuities within their plan, only to have the annuity issuer default on the payments required under the annuity. SECURE 2.0 failed to provide similar protections for plan participants who suffer losses in such circumstances.

The pro-annuity provisions of SECURE 2.0 remind me of the court’s words in Hirshberg & Norris v. SEC, where the court rejected the defendant’s suggestion that the securities laws were intended to protect the investment industry, the court stating that

[t]o accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protection of the broker-dealer rather than for the protection of the public. On the contrary, it has long been recognized by the federal courts that the investing and usually naive public need special protection in this specialized field.3

Replace the reference to “securities” with “ERISA” and “broker-dealers” with “annuity industry” and I believe the court’s words are equally applicable to the current situation facing plan sponsors, as annuity salesmen try to convince them to include annuities in their plans.

The annuity industry continually bemoans the fact that they cannot get more plan sponsors, and investment fiduciaries in general, to offer annuities. I talk to plan sponsors on a regular basis and the story on their reluctance to offer annuities is generally some variation of the following:

  • Distrust of the annuity industry due to (1) the perceived lack of full and meaningful disclosure, and (2) the refusal of the annuity industry to acknowledge and address the genuine fiduciary liability issues that plan sponsors face due to design and overall complexity issues with annuities.
  • The impact of the costs and fees typically associated with annuities, resulting in a potential breach of a plan sponsor’s duty of prudence. While annuity advocates often play a game of semantics, stating that annuities doe do charge “fees,” the reality is that annuities often have significant “costs” which are “hidden” in an annuity’s “spread.” Furthermore, such spreads, often 1-2 percent, or more, are taken prior to the annuity issuer calculating the amount of interest to be credited to the annuity owner, raising genuine potential fiduciary breach issues for plan sponsors including them in a plan.
  • The difficulty and/or inability of plan sponsors to perform the legally independent investigation and evaluation of a product required by ERISA. The courts have warned plan sponsors that reliance on commissioned salespeople for advice is not legally reasonable or justifiable due to the inherent conflicts of interest in such situations.
  • The frequent inclusion of certain complicated and confusing provisions within annuity contracts that protect the annuity issuer’s interests at the expense of an annuity owner’s expense, resulting in a breach of a plan sponsor’s duties of loyalty and prudence.
  • The frequent inclusion of certain provisions within annuity contracts that require the annuity owner to surrender ownership and control over both the annuity contract and the accumulated value of the contract, with no guarantee of a commensurate return for the plan participant, in order for the annuity owner to receive the “guaranteed income for life” benefit. This scenario could potentially result in a windfall for the annuity issuer at the plan participant’s expense, a clear breach of a plan sponsor’s duties of loyalty and prudence.

Chris Tobe, one of my fellow co-founders on “The CommonSense 401(k) Project” has written extensively on a number of factors that generally result in annuities being a liability trap for fiduciaries. Two of the primary factors Chris cites are the single entity credit risk and illiquidity issues associated with annuities. Chris has extensive experience in the design and analysis of annuities. Plan sponsors should read Chris’ excellent analyses.

A full and complete analysis of the analysis is beyond the scope of this post. At the end of thois post I have included a list of various studies and other resources that I recommend to all of my fiduciary risk management clients. I highly recommend that plan sponsors invest the time to read these resources in order to understand the potential liability “traps” inherent in annuities.

Indexed Annuities
There are several passages in particular that I feel summarize the key legal fiduciary liability issues thatt annuities present, passages that support the distrust issues that plan sponsors and other investment fiduciaries often mention to me. Equity-indexed annuities are currently a popular form of annuities. Dr. William Reichenstein is a well-respected expert in financial services. Dr. Reichenstein has authored several articles on the financial inefficiency of equity-indexed annuities. Among his findings and conclusions:

Indexed annuities (IA) including equity indexed annuities (EIAs) are complex investment contracts. (citing features such as surrender penalties; an annuity’s “spread;” arbitrary restrictions on returns that owners can actually achieve, e.g., caps and participation rates, and ability to reset same on a regular basis and on such terms at the annuity issuer desires; market value adjusted options penalizing an annuity owner who withdraws money from an annuity before term, various interest crediting methods and potential interest forfeiture rules e.g., annual reset, point-to-point, or high water point; potential interest forfeiture rules; the issue of averaging and they type of averaging used.4

More important, because of their design, index annuities must underperform returns on similar risk portfolios of Treasury’s and index funds. EIAs impose several risks that are not present in market-based investments including surrender fees and loss of return on funds withdrawn before the end of the term. This research suggests that salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.5

The interest credited on an EIA is based on the price index. So, the investor may get part of the price appreciation, but she does not receive any dividends associated with the underlying stock index. The return may be further reduced based on participation rate, spread, and cap rate. Moreover, the insurance firm almost always has the ability to adjust at its discretion the participation rate, spread, or cap rate at the beginning of each term.6

When annuity advocates questioned his findings, Reichenstein provided a follow-up paper responding to the advocates’ criticisms as follows:

I concluded that because of their structure “all indexed annuities must produce below-market, risk-adjusted returns.”7

As discussed by Reilly and Brown (2009, p. 549), to try to add value compared with a passive investment strategy, active managers use one of three generic themes: (1) market timing; (2) overweighing stocks by sectors/ industries, overweighing value or growth stocks, or overweighing stocks by size; and (3) through security selection. All attempts to beat a market index on a risk-adjusted basis use one or more of these three themes. By design, indexed annuities cannot add value with any of these themes.8

By design, (1) they do not attempt market timing, (2) they do not make sector/industry/ style/size bets, and (3) they do not try to add value through security selection. Furthermore, because hedging strategies usually require long and short positions in options contracts, the industry cannot argue that indexed annuity strategies beat the market because option values are consistently undervalued or overvalued. So, I concluded that the risk-adjusted returns on indexed annuities must trail the risk-adjusted returns available in marketable securities by the sum of their spread plus their transaction costs.9

In short, because of their design, indexed annuities cannot add value to offset their substantial embedded costs.10

In support of his argument, Reichenstein referenced a study by two-well respected members of the financial services community, Nobel laureates Eugene Fama and Kenneth French  Fama and French cited the research of Dr. William F. Sharpe and the arithmetic of equilibrium accounting, declaring that

To put this argument in the context of indexed annuities, we do not need empirical tests to ensure that IAs underperform their risk-adjusted benchmark portfolio’s returns. Because their structure prevents them from adding value compared to this benchmark return, they must underperform this benchmark return by the sum of their spread plus their transaction costs.11

McCann and Luo studied equity-indexed annuities and best summarized my opinion toward equity-indexed annuities in the context of fiduciary risk management:

[The] net result of equity-indexed annuities’ complex formulas and hidden costs is that they survive as the most confiscatory investments sold to retail investors.12

Terry and Elder analyzed Reichenstein’s research and offered the findings of their own research on equity-indexed annuities.

[Reichenstein’s] essential point is that indexed annuities are simply repackaging returns that are already available to investors in the market place without adding any potential security selection or market timing value. The cost of this repackaging is the ‘spread.’ In summary, the simple economics of [equity-indexed annuities] is that investors are paying 2-3% annually in investor spreads to receive returns similar to those already available in the market, trivial insurance benefits, and to receive a no loss guarantee.13

Insurance companies [typically reserve] the option of changing many of the {index annuity’s] contract features after the first year. In particular they change the participation rates, spreads, and cap rates to maintain their investment spreads.” In other words, annuity issuers reserve the right to reduce the annuity’s owner’s return in order to maintain their investment spread.14

The opportunity costs of investing in [indexed annuities] over long horizons compared with reasonable and implementable alternative strategies are quite high….{A]t a minimum, these opportunity costs should be disclosed to potential  investors at time of purchase.15

I believe the same sentiments are equally applicable to fiduciary responsibilities with regard to 401(k) and 403(b) plan and provide valuable risk management advice for plan sponsors with regard to equity-indexed annuities.

John Olson, a respected expert on annuities, provided an excellent summary on the key issues involving index annuities:

Owners of index annuities will almost never receive the full amount of gain that was realized by the index chosen. That is because there is rarely enough money left over after buying the bonds required to back the contractual guarantees to buy enough options on the index to get the full amount of any gain in that index. This is one reason why it is not true that an index annuity owner gets the upside of the market with no downside risk. At best, he or she will receive only a portion of index gain, both because the insurer could not buy enough option to get that full gain and because many index annuities limit the amount of index-linked interest that it will credit. (It does so because the specialized call options it purchases are themselves limited by a cap, allowing the insurer to purchase more upside potential than it could without such a cap.)16

Olson’s paper addresses several myth and misconception about index annuities, including Olson refuting the annuity industry’s popular “cannot lose money-no risk” claim.

It is possible–if one withdraws money from or cash (sic) in the contract during the surrender charge period. While some contracts have a genuine guarantee of principal (surrender charges my wipe out interest earned but not the money contributed in premiums) that preserves premium even in the early contract years, most do not. That said, negative performance in the chosen index or indices will not erode the contract’s cash value Thus, previously credited interest cannot be lost due to bad index performance.17

Remember the point regarding the plan sponsor’s fiduciary responsibilities on the ability to determine and analyze the interest crediting method utilized by a annuity issuer? As previously notes, the courts have warned plan sponsors that reliance on commissioned salespeople does meet the “reasonable reliance” requirement for hiring experts.

Variable Annuities
A second type of annuity sometimes appearing in 401(k) and 403(b) plans is variable annuities (VAs). I have previously written on both this blog and my “CommonSense InvestSense” blog about the potential liability issues involved with variable annuities. The “CommonSense InvestSense” blog is more directed toward on individual investors.

Over the ten-plus years that I have written the “CommonSense InvestSense” blog, one post in particular has generated the most responses, “Variable Annuities: Reading Between the Marketing Lines.” I continue to get people thanking me for an objective and plain-English explanation of an otherwise complex product. More rewarding was the fact that most people told me that the article persuaded them to avoid variable annuities altogether.

As with equity-indexed annuities, I believe that variable annuities are fiduciary liability “traps.” Interestingly enough, some insurance executives share the same concerns.

Again, a full and complete discussion and analysis is beyond the scope of this post. The purpose of this post is to hopefully raise awareness of genuine fiduciary liability issues inherent with annuities and the need for plan sponsors to consider such issues.

The three most concerning issues from a fiduciary liability standpoint are (1) the use of “inverse pricing” often used in calculating a VA’s annual M&E/death benefit fee, (2) the cost-inefficiency of many of the investment sub-accounts offered with the VA, and (3) the fact that equity-indexed annuities are typically structured in such a way as to promote a windfall for the annuity issuer at the annuity owner’s expense. This inequitable situation results when annuities condition the receipt of the alleged benefit, “guaranteed income for life,” on the annuity owner surrendering both the annuity contract and the accumulated value within the VA to the annuity issuer, with no guarantee that the annuity owner will receive a commensurate return.

I refer you to my “CommonSense InvestSense” blog post for a more complete analysis of the legal liability issues involved with VAs.

For this post, I just want to touch on three common sales pitches used in VA sales so that plan sponsors can recognize and avoid them.

1. Annuity owners do not pay a sales charge, so more of their money goes to work for them.

The statement that variable annuity owners pay no sales charges, while technically correct, is misleading. Variable annuity salespeople do receive a commission for each variable annuity they sell, such commission usually being a percentage of the total amount invested in the variable annuity.

While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through a variable annuity’s various fees and charges, particularly the M&E charge.

To ensure that the cost of commissions paid is recovered, the insurance company typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for an initial surrender charge for withdrawals during the first year, decreasing 1 percent each subsequent year thereafter until the surrender charges end. There are some surrender charge schedules that charge a flat rate over the entire surrender charge period.

2. The inherent value of the VA’s death benefit is highly questionable and often grossly excessive.

[T]he fee [for the death benefit] is included in the so-called Mortality and Expense (M&E) risk charge. The M&E risk charge is a perpetual fee that is deducted from the underlying assets in the VA, above and beyond any fund expenses that would normally be paid for the services of managed money.18

[T]he authors conclude that a simple return of premium death benefit is worth between one to ten basis points, depending on purchase age. In contrast to this number, the insurance industry is charging a median Mortality and Expense risk charge of 115 basis points, although the numbers do vary widely for different companies and policies.19

The authors conclude that a typical 50-year-old male (female) who purchases a variable annuity—with a simple return of premium guaranty—should be charged no more than 3.5 (2.0) basis points per year in exchange for this stochastic-maturity put option. In the event of a 5 percent rising-floor guaranty, the fair premium rises to 20 (11) basis points. However, Morningstar indicates that the insurance industry is charging a median M&E risk fee of 115 basis points per year, which is approximately five to ten times the most optimistic estimate of the economic value of the guaranty.20

Excessive and unnecessary costs violate the fiduciary duty of prudence. The value of a VA’s death benefit is even more questionable given the historic performance of the stock market. As a result, it is unlikely that a VA owner would ever need the death benefit. These two points have resulted in some critics of VAs to claim that a VA owner needs the death benefit like a duck needs a paddle.”

3. The “inverse pricing” method used by many VAs is inequitable.

VA advocates tout various benefits. Anyone considering a VA should also consider the question-“at what cost?” VAs often calculate a VA’s annual M&E charge/death benefit based on the accumulated value within the VA, even though contractually they typically limit their legal liability under the death benefit to the VA owner’s actual investment in the VA.

As a result, over time, it is reasonable to expect that the accumulated value within the VA will significantly exceed the VA owner’s actual investment in the VA. This method of calculating the annual M&E, known as “inverse pricing,” results in a VA issuer receiving a windfall equal to the difference in the fee collected and the VA issuer’s actual costs of covering their legal liability under the death benefit guarantee.

As mentioned earlier, fiduciary law is a combination of trust, agency, and equity law. A basic principle of equity law is that “equity abhors a windfall.” The fact that VA issuers knowingly use the inequitable inverse pricing method to benefit themselves at the VA owner’s expense results in a fiduciary breach for fiduciaries who recommend, sell or use VAs in their practices or in their pension plans.

The industry is well aware of this inequitable and counter-intuitive situation. John D. Johns, a CEO of an insurance company, addressed these issues in an article entitled “The Case for Change.”

Another issue is that the cost of these protection features is generally not based on the protection provided by the feature at any given time, but rather linked to the VA’s account value. This means the cost of the feature will increase along with the account value. So over time, as equities appreciate, these asset-based benefit charges may offer declining protection at an increasing cost. This inverse pricing phenomenon seems illogical, and arguably, benefit features structured in this fashion aren’t the most efficient way to provide desired protection to long-term VA holders. When measured in basis points, such fees may not seem to matter much. But over the long term, these charges may have a meaningful impact on an annuity’s performance.21

In other words, inverse pricing is always a breach of a fiduciary’s duties of both loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without any commensurate return, which also violates Section 205 of the Restatement of Contracts.

In other words, the use of inverse pricing is always a breach of a fiduciary’s duties of loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without a commensurate return, which also violates Section 205 of the Restatement of Contracts.

Going Forward
As shown herein, annuities have the ability to raise genuine fiduciary liability issues for plan sponsors. Those issues may become even more problematic for plan sponsors in the near future in connection with 401(k)/403(b) litigation. While some federal courts are already placing the burden of proof regarding causation of damages on plan sponsors, there is still a split in the federal courts.

There is currently a case, Matney v. Briggs Gold of North America22, which will seemingly force the legal system, most likely the Supreme Court, to establish one consistent standard for courta in 401(k)/403(b) actions. Given the fact that the First Circuit Court of Appeals and other federal circuits, the United States Solicitor General, and more recently the Department of Labor have expressed support for shifting said burden of proof to plan sponsors, the likelihood is that the Supreme Court would follow suit and rule in favor of such a policy, especially since it is consistent with the common law of trusts.

In talking with my clients about the issue of annuities in 401(k) and 403(b) plans, I ask them whether they will be able to carry the burden of proof as to causation, be able to calculate and verify the guaranteed benefits such as the interest crediting payments received within such annuities to ensure both the prudence of the products and that a plan participant’s ERISA rights are not being violated.

Similarly, will a plan sponsor be able to determine which index interest crediting model is in a plan participant’s best interests, e.g., one year annual reset, multiple year point to point, one-year monthly cap index, one-year averaged monthly? Will plan sponsors be able to determine whether the index used in such indexed annuities is legitimate and in the plan participants’ best interests? Suddenly, the simplicity of index funds is looking better and better.

Plan sponsors, and investment fiduciaries in general, need to understand the significant, and irreconcilable differences, between the insurance/ annuity industry model and the ERISA/fiduciary law model. The insurance/ annuity industry is all about managing the odds, managing risk in such a way to ensure that the odds are in their favor, that their best interests take precedence over those of their customers, that losses are offset by gains to ensure their overall profitability.

ERISA and fiduciary law is just the opposite, the focus being on equity, fundamental fairness, and certainty, always acting in such a way that the plan participant’s best interests are best served. With fiduciary law, the fiduciary gets one chance to “get it right,” there are no “mulligans” or do-overs. Furthermore, the recent SCOTU’ and Seventh Circuit Hughes23 decisions clearly establish that the concept of offsets is not recognized under ERISA/fiduciary law.

One can legitimately argue that the basic concept and structure of an annuity is the anti-thesis of fiduciary law and equitable principles. Conditioning an annuity owner’s receipt of the advertised benefits of “guaranteed income for life,” with “no investment losses,” upon the annuity owner’s surrendering both the control and ownership of both the annuity contract and the accumulated value within the annuity, without any guarantee of receiving a commensurate return, is not only fundamentally unfair and inequitable, but clearly inconsistent with both the fiduciary duty of prudence and loyalty, as it increases the odds of a windfall in favor of the annuity issuer at the annuity owner’s expense. “Equity abhors a windfall is a basic tenet of equity law, which is basic component of fiduciary law.

The typical response of annuity advocates to such criticism-that annuity owners can purchase a rider to ensure the return of their principal-does not satisfy such fiduciary law and liability concerns and only serves to further reduce the annuity’s owner’s effective end-return. Both the Department of Labor and the General Accountability Office have noted that each additional 1 percent in fees/costs reduces an investor’s end-return by approximately 17 percent over a 20-year period.24

There is a familiar expression in the investment and annuity industries-“sell the sizzle, not the steak.” That describes the marketing strategy typically used by the annuity industry, with the “guaranteed income for life” and “no risk” spiels being the “sizzle.” The inequities aspects of annuties discussed herein, inequities designed to serve the best interests of the annuity issuer, not the annuity owner, are obviously the “steak.”

Fiduciary investment risk management 101-Keep It Simple & Smart. Once again, the best strategy for avoiding unnecessary fiduciary investment risk is to avoid it altogether whenever possible. Neither ERISA nor any other law expressly requires plan sponsors to offer annuities within a 401(k) or 403(b) plan. Plan participants desiring to purchase an annuity are free to do so outside the plan, without exposing the plan sponsor to any unnecessary fiduciary liability risk.

Notes
1. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003). (Gregg)
2. Gregg, 841-842.
3. 117 F.2d 228, 233 (1949).
4. Reichenstein, W. (2009) Financial analysis of equity indexed annuities. Financial Services Review, 18, 291-311, 291 (Reichenstein I)
5. Reichenstein I, 291.
6. Reichenstein I, 298.
7. Reichenstein, W. (2011) Can annuities offer competitive returns? Journal of Financial Planning, 24, 36. (Reichenstein II)
8. Reichenstein II, 36.
9. Reichenstein II, 36.
10. Reichenstein II, 36-37.
11. Fama, E. F. & French, K. R. (2009) Why Active Investing Is a Negative Sum Game, (available at http://www.dimensional.com/famafrench/2009/06/why-active-investing-is-a-negative-sum-game.html)
12. McCann, C. & Luo, D. (2006) An Overview of Equity-Indexed Annuities. Working Paper, Securities Litigation and Consulting Group (McCain & Luo
13. Terry, A. & Elder, E. (2015) A further examination of equity-indexed annuities. 24, 411-428, 416. (Terry & Elder)
14. Terry & Elder, 419.
15. Terry & Elder, 427.
16. Olson, J. (November 2017) Index Annuities: Looking Under the Hood. Journal of Financial Services Professionals. 65-73, 71,
17. Olson, 72.
18. Milevsky, M. &  Posner, S. The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126, 92. (Milevsky & Posner)
19. Milevsky & Posner, 92.
20. Milevsky & Posner, 92.
21. Johns, J. D. (September 2004) The Case for Change, Financial Planning 158-168, 158. (Johns)
22. Matney v. Briggs Gold of North America, No. 4045 (10th Cir. 2022)
23. Hughes v. Northwestern University, No. 18-2569, March 23, 2023 (7th Cir. 2023); Hughes v. Northwestern University, 142 S.Ct. 737 (2022)
24. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (“DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”).

Recommended Reading
Collins, P.J., Lam, H., & Stampfi, J. (2009) Equity indexed annuities: Downside protection, but at what cost? Journal of Financial Planning, 22, 48-57.

FINRA Investor Insights (2022) The Complicated Risks and Rewards of Indexed Annuties  The Complicated Risks and Rewards of Indexed Annuities | FINRA.org

Fama, E. F. & French, K. R. (2009) Why Active Investing Is a Negative Sum Game, (available at http://www.dimensional.com/famafrench)

FINRA Investor Alert (2003) Variable Annuities: Beyond the Hard Sell

Frank, L., Mitchell, J. & Pfau, W. Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios, Journal of Financial Planning, April 2014, 38-47. 

Katt, P. (November 2006) The Good, Bad, and Ugly of Annuities AAII Journal, 34-39.

Lewis, W. Chris. 2005. A Return-Risk Evaluation of an Indexed Annuity Investment.” Journal of Wealth Management 7, 4.

McCann, C. & Luo, D. (2006). An Overview of Equity-Indexed Annuities. Working Paper, Securities Litigation and Consulting Group.

Milevsky, M. & Posner, S. The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126.

Olson, J. Index Annuities: Looking Under the Hood. Journal of Financial Services Professionals. 65-73 (November 2017),

Reichenstein, W. Financial analysis of equity-indexed annuities. Financial Services Review, 18 (2009) 291-311.

Reichenstein, W. (2011), Can annuities offer competitive returns? Journal of Financial Planning, 24, 36.

Securities and Exchange Commission. (2008) Investor Alerts and Bulletins: Indexed Annuties SEC.gov | Updated Investor Bulletin: Indexed Annuities

Sharpe, W.F. (1991) The arithmetic of active management. Financial Analysts Journal, 47, 7-9.

Terry, A. & Elder, E. (2015) A further examination of equity-indexed annuities. 24, 411-428.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Annuities, best interest, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investments, Mutual funds, pension plans, plan sponsors, prudence, retirement planning, retirement plans, risk management, SCOTUS, Supreme Court, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , | Leave a comment

The Active Expense Ratio: Fiduciary Risk Management’s “Little Secret”

By James W. Watkins, J.D., CFP Board Emeritus™, AWMA®

When I created the Active Management Value Ratio (AMVR) metric, the goal was to create a simple tool that would allow investors, investment fiduciaries, and attorneys to quickly and easily evaluate the cost-efficiency and, thus, the fiduciary prudence of an actively managed mutual fund. The metric itself is based on a combination of research and concepts of investment icons such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel.

T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.7

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!2

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover.3  

These three opinions formed the basis for the initial iteration of the AMVR. Further research led to the current version of the AMVR – AMVR 3.0 – which incorporates the research of Ross Miller and his Active Expense Ratio (AER) metric. Miller explains the importance of the AER as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.4

An example of an AMVR analysis of the retirement share of a well-known actively managed mutual fund is shown below.

An AMVR analysis can be calculated for any time period. In this case, a five-year analysis comparing an actively managed fund and a comparable index fund shows that the actively managed fund is cost-inefficient, as it fails to provide a positive incremental return (1.33), so naturally the incremental costs exceed the incremental returns. A cost-inefficient fund is an imprudent investment under the Restatement (Third) of Trusts.

The example show above is far from an anomaly. Research has consistently shown that the overwhelming majority of actively managed funds are cost-inefficient.


99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.5  

Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.6

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.7

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.8

The cost-inefficiency in the example is even more serious if measured using the AER, In this case, the high incremental costs of the funds combined with the fund’s high correlation of return to the benchmark (98) results in an AER of 5.67.

In Tibble,9 SCOTUS recognized the Restatement (Third) of Trusts (Restatement) as a legitimate resource in resolving fiduciary disputes, including questions regarding fiduciary duties under ERISA. The Restatement clearly recognizes the importance of cost-efficiency, stating that fiduciaries should carefully compare the costs associated with a fund, especially when considering funds with similar objectives and performance. The Restatement advises plan fiduciaries that in deciding between funds that are similar except for their costs, the fiduciary should only choose an active fund with higher costs and/or risks if

the course of action in question can reasonably be expected to compensate for its additional costs and risk,…10

Studies by both the DOL and the GAO have found that each additional one percent in fees/costs reduces an investor’s end-return by 17 percent over a 20-yeat period.11 In our example, that would result in a projected loss of 45 percent using the nominal incremental cost/underperformance numbers (2.63), and 94 percent using the AER incremental cost/underperformance numbers (5.52).

The Active Expense Ratio – Fiduciary Risk Management’s “Little Secret”
Whenever I show a prospective fiduciary risk management client a sample AMVR analysis, one of the first questions is about the AER column and why is it important. Miller’s quote obviously addresses the significance of the AER.

In my last post, I referenced a similar quote in a 2007 speech from then SEC General Counsel, Brian G. Cartwright. Cartwright asked his audience to think of an investment in an actively managed mutual fund as a combination of two investments: a position in an “virtual” index fund designed to track the S&P 500 at a very low cost, and a position in a “virtual” hedge fund, taking long and short positions in various stocks. Added, together, the two virtual funds would yield the mutual fund’s real holdings.

The presence of the virtual hedge fund is, of course, why you chose active management. If there were zero holdings in the virtual hedge fund — no overweightings or underweightings — then you would have only an index fund. Indications from the academic literature suggest in many cases the virtual hedge fund is far smaller than the virtual index fund. Which means…investors in some of these … are paying the costs of active management but getting instead something that looks a lot like an overpriced index fund. So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether or not they’re getting the desired bang for their buck?12

The AER provides investors, investment fiduciaries, and ERISA attorneys with just the tool to provide such information. The AER for an actively managed fund can be calculated with just the actively managed fund’s r-squared information and the fund’s incremental cost data.

In the AMVR analysis above, the actively managed fund had an r-squared, or correlation of returns, number of 98. Miller then provides an equation for calculating the percentage of active management provided by the actively managed fund relative to a comparable index fund. In this case, the r-squared number of 98 equates to an implied active weight of 12.50 percent.

Over the last decade or so, it has not been uncommon for U.S. domestic equity funds to have r-squared numbers of 95 and above, resulting in relatively low active weight numbers, typically less that 25 percent. The list below shows the active weights associated with r-squared number of 95 and above.

99 > .0913
98 > .1250
97 > .1537
96 > .1695
95 > .1866

The AER is then calculated by dividing the actively managed fund’s incremental costs by the actively managed fund’s active weight number. Here, the actively managed fund’s incremental costs (0.42) divided by the fund’s active weight (.125) results in an AER score of 3.36, or seven times the actively managed fund’s publicly reported expense ratio.

Another way of combining the AMVR and the AER is to use the data to determine how you would have rationalized the imprudence of a choice of the actively managed fund in a 401(k)/403(b) action. ERISA plaintiff attorneys are increasingly using the AER in bracketing estimated damages. The argument would be given the actively managed fund significantly underperformance the comparable index fund, the index fund would have not only have provided plan participants with a significantly better return, but the incremental return would not have been incurred, thereby increasing the plan participants’ returns even more. As John Bogle was fond of saying, “Investors keep what they don’t pay for.”

Going Forward
As some courts continue to try to justify the use of cost-inefficient active funds in 401(k) plans, an often-unaddressed issue involves the fundamental issues of just how much active management do “actively” managed funds actually provide and at what cost to investors

The high correlation of returns that is being seen between U.S. domestic equity funds and comparable index funds naturally raises the question of “closet indexing.” Closet index funds tout the alleged benefits of active management and try to justify higher expenses ratios and costs on such alleged benefits.

The financial implications of closet indexing for investors are well-known.  

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….13 

The AER makes plan sponsors and other investment fiduciaries address the uncomfortable question of closet indexing and the resultant cost-inefficiency and legal imprudence of such funds. The AER recognizes that a high correlation of returns between a “actively managed” fund and a comparable index fund suggests that active management is contributing little, if anything, in terms of performance and return for an investor. The AER recognizes that the combination of a high r-squared number and high incremental costs increases a fund’s implicit costs and overall cost-inefficiency.

The AER should make courts and plan sponsors realize that the implicit costs of funds that provide a low level of active management, funds with a low active weight/active contribution, are naturally going to be higher than a fund that truly provides active management. The AER raises the fundamental question of how much “active management” must a fund provide to qualify as an actively managed fund and avoid potential allegations of fraud and misrepresentation under federal securities laws.

The Department of Labor (DOL) recently filed an amicus brief in a pending 401(k) action. The significance of the amicus brief is that the DOL sided with both several other federal circuit courts of appeal and the common law in taking the position that plan sponsors, not plan participants, have the burden of proof with regard to the issue of causation in 401(k)/403(b) litigation. This issue is currently involved in two pending federal 401(k) litigations.

Now that the DOL has taken a position that is consistent with both a previous amicus brief filed with SCOTUS by the Solicitor General in the Brotherston14 case and a significant portion of the federal courts of appeal, I believe that SCOTUS will ultimately agree the burden of proof on the issues of causation shifts to the plan sponsor once the plan participants properly plead their case.

With ERISA plaintiff attorneys already incorporating the AER in calculating damages, plan sponsors need to ask themselves whether they could carry that burden of proof. I believe that the studies referenced herein, as well as the AMVR, raise genuine doubts about the ability of plan sponsor to meet that challenge. That is many of my fiduciary risk management clients are already proactively using both the AMVR and the AER to estimate and reduce the extent of any potential fiduciary liability exposure.

Notes
1. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
2. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
3. Burton G. Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
4. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926.
5. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
6. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
7. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
9. Tibble v. Edison International, 135 S. Ct 1823 (2015).
10. Restatement (Third) Trusts (American Law Institute), cmt. h(2). All rights reserved. (Restatement)
11. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (“DOL Study”); “Private Pensions: Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (“GAO Study”).
12. SEC Speech: The Future of Securities Regulation: Philadelphia, Pennsylvania: October 24, 2007 (Brian G. Cartwright). http://www.sec.gov/news/speech/2007/spch102407bgc.htm
13. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What They Pay For?:The Legal Consequences of Closet Index Fundshttps://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133 (Cremers), 5, 42.
14. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018). (Brotherston)

Copyright InvestSense, LLC 2023. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.



Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, asset allocation, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investment advisers, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement planning, retirement plans, risk management, SCOTUS, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , | Leave a comment

Common Sense and Fundamental Fairness: The Matney Case and the Future of 401(k)/403(b) Litigation

By James W. Watkins, J.D., CFP Board Emeritus™, AWMA®

I have referenced the Matney v. Briggs Gold of North America (Matney) case1 in a number of recent posts. In my opinion, the significance of Matney lies in the fact that the case presents an opportunity to consider the same issues that were presented in the Brotherston v. Putnam Investments, LLC case2 (Brotherston) back in 2018.

SCOTUS ultimately denied Putnam’s petition for certiorari, presumably based on the Solicitor General’s recommendation to deny cert since the petition involved an interlocutory appeal. While the Solicitor General recommended denying the petition, his amicus brief completely supported the First Circuit’s decision.3

Two key issues involved in both Brotherston and Matney – the legitimacy of index funds as comparators in 401(k)/403(b) litigation, and which party had the burden of proof on the issue of causation in such cases. As to the first issue, both the First Circuit and the Solicitor General pointed to SCOTUS’ previous recognition of the Restatement (Third) of Trusts (Restatement) as a valuable resource in resolving fiduciary issues.4 Both parties pointed to Section 100, comment b, of the Restatement, which states that comparable indices and index funds are legitimate comparators in addressing questions of fiduciary prudence.

As to the second question, both the First Circuit and the Solicitor General stated that under the common law of trusts, once a plaintiff establishes a breach of fiduciary duty and a resulting loss, the burden of proof as to causation shifts to the fiduciary. This position is based on common sense and necessity since only the fiduciary knows the processes, if any, that were used and relied on in making their decisions. The Sixth Circuit recognized this issue in its TriHealth decision:

But at the pleading stage, it is too early to make these judgment calls. ‘In the absence of further development of the facts, we have no basis for crediting one set of reasonable inferences over the other. Because either assessment is plausible, the Rules of Civil Procedure entitle [the three employees] to pursue [their imprudence] claim (at least with respect to this theory) to the next stage….’5

This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth ‘investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares’ because ‘the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….’ Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.6

The Opportunity Provided by Matney
While Matney is still pending in the Tenth Circuit, I believe that it is reasonable to assume that the Tenth Circuit’s decision will be ultimately be appealed to SCOTUS given the importance of the issues involved. Just as in Hughes, there is a split in the federal courts, in this case on the both the “apples and oranges” and the burden of proof on causation issues, effectively denying workers a consistent and equitable enforcement of the rights and protections guaranteed under ERISA.

The district court’s decision started out strong, recognizing that the processes used by a plan sponsor are determinative in assessing the fiduciary prudence of their selection of a plan’s investment decisions.

But Plaintiffs do not challenge decisions specific to the options in which they invested. They focus on an allegedly flawed process that resulted in investment offerings Plaintiffs say were imprudent and unnecessarily cost them money…Plaintiffs allege infirmities in the overall decision-making process, and that confers standing to challenge decisions that happened to affect not only their accounts but other accounts in the Plan the fiduciaries managed.7 

The court recognizes that plaintiffs have limited access to information demonstrating the process fiduciaries use to make their decisions. But a plaintiff can survive a motion to dismiss if the court can infer from the circumstantial allegations that the fiduciary’s decision-making process was flawed. (citing Pension Benefit Guar. Corp. ex. rel. St. Vincent Catholic Med. Ctr.’s Ret. Plan v. Morgan Stanley Inv. Mgmt. Inc., 712 F.3d 705, 719–20 (2d Cir. 2013); Braden v. WalMart Stores, Inc., 588 F.3d 585, 596 (8th Cir. 2009).8

Nevertheless, circumstantial factual allegations “must give rise to a ‘reasonable inference’ that the defendant committed the alleged misconduct, thus ‘permit[ting] the court to infer more than the mere possibility of misconduct.” (citing St. Vincent, 712 F.3d at 718–19 (emphasis in original) (quoting Iqbal, 5556 U.S. at 678–79)).9 

Then the district court proceeded to make some interesting statements regarding the use of revenue sharing in reducing the expense ratios of funds and other investments, as well as the consideration of other fiduciary prudence factors. The court rejected the plaintiff’s use of collective investment trusts (CITs) as comparators, citing differing strategies and the familiar “apples and oranges” argument.

Importantly, Plaintiffs misstate expense ratios of Plan funds. But they also make “apples to oranges” comparisons that do not plausibly infer a flawed monitoring and decision-making process. “To show that ‘a prudent fiduciary in like circumstances’ would have selected a different fund based on the cost or performance of the selected fund, a plaintiff must provide a sound basis for comparison—a meaningful benchmark.” (citing Meiners, 898 F.3d at 822) The fact that “cheaper alternative investments with some similarities exist in the marketplace” does not provide a “meaningful benchmark” upon which to determine whether the Committee breached its duty. (citing Meiners, at 823) (emphasis in original).10

The district court seemingly overlooked the fact that the Restatement effectively discredits the “apples and oranges” and recognizes comparable indices and index funds as “meaningful benchmark”. The court seemingly ignored the fact that SCOTUS endorsed the use of the Restatement in cases where ERISA does not provide express instructions/requirements.11

The district court’s attempt to use revenue sharing to reduce a fund’s expense ratio is totally inconsistent with the Seventh Circuit’s acknowledgment that such attempts to offset expense ratios with revenue sharing payments on a one-to-one basis are improper.12 In another example of the “fundamental fairness” trend, the Seventh Circuit rejected the district court’s one-to-one offset argument.

The problem is that the Form 5500 on which Albert relies does not require plans to disclose precisely where money from revenue sharing goes. Some revenue sharing proceeds go to the recordkeeper in the form of profits, and some go back to the investor, but there is not necessarily a one-to-one correlation such that revenue sharing always redounds to investors’ benefit. Albert’s ‘net investment expense to retirement plans theory’ assumes that there is such a correlation; if that assumption is wrong, then simply subtracting revenue sharing from the investment-management expense ratio does not equal the net fee that plan participants actually pay for investment management.13

The Hughes/TriHealth Prescription
The Seventh Circuit’s Hughes decision frequently cited the Sixth Circuit’s TriHealth decision in describing the current 401(k)/403(b) litigation standards.

1. ERISA requires a fiduciary to assess whether a given fund is prudent in light of other investment options in a plan, comparable funds, and the expenses charged, among other factors.14
2. At the pleading stage, a plaintiff must provide enough facts to show that a prudent alternative action was plausibly allege fiduciary decisions outside a range of reasonableness.15
3. The duty of prudence requires a plan fiduciary to “incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.”16
4. At the pleading stage, a plaintiff must provide enough facts to show that a prudent alternative action was plausibly available.17
5. Every possible alternative explanation for an ERISA fiduciary’s conduct need not be ruled out at the pleadings stage.18
6. Where alternative inferences are in equipoise – that is where they are all reasonable based on the facts – the plaintiff is to prevail on a motion to dismiss. This is because, at the pleading stage, we must accept all well-pleaded facts as true and draw reasonable inferences in the plaintiff’s favor.19

Matney provides a perfect opportunity for SCOTUS to further create a uniform, consistent set of standards for 401(k)/403(b) litigation. The recognition of the “apples and oranges” argument is a consistent and inexplicable refusal of some federal courts to ignore SCOTUS and ignore the Restatement’s common sense fiduciary standards.

In Matney, the district court recognized that process, not product, is the key issue in 401(k)/403(b) litigation. Two statements in particular drew my attention:

(1) “circumstantial factual allegations ‘must give rise to a ‘reasonable inference’ that the defendant committed the alleged misconduct, thus ‘permit[ting] the court to infer more than the mere possibility of misconduct,”20 and

(2) “[t]o show that ‘a prudent fiduciary in like circumstances’ would have selected a different fund based on the cost or performance of the selected fund, a plaintiff must provide a sound basis for comparison—a meaningful benchmark.”21 (emphasis added)

Change “cost or performance” to “cost and performance” and I believe the letter and spirit of ERISA can be easily, and uniformly, accomplished. People who follow my posts are well aware of my position that the relative cost-efficiency of a fund, not its classification as active or passive, should be the key factor in determining whether a plan sponsor or any other investment fiduciary has breached their fiduciary duties.

In Hughes, the Seventh Circuit noted that “cost-consciousness management is fundamental to prudence in the investment function. The Active Management Value Ratio (AMVR) metric provides a simple method of assessing the cost-efficiency of a fiduciary’s decisions. A sample of an AMVR analysis slide is shown below.

The slide clearly establishes a “reasonable inference” of a fiduciary breach, clearly showing the cost-inefficiency of the actively managed mutual fund relative to a comparable index fund based on the actively managed fund’s incremental cost and return. The combination of the active fund’s relative underperformance (opportunity cost) and the fund’s incremental expense ratio cost could then be used to estimate both the loss and damages caused by the plan sponsor’s fiduciary breach.

The AMVR itself is simply the basic cost/benefit equation, using incremental cost/return as the input data. The AMVR calculation itself is obtained by dividing an active fund’s incremental cost by its incremental return. An AMVR greater than “1.0” indicates that the actively managed fund is cost-efficient.

Plan sponsors, attorneys and courts can then see the extent of the cost-inefficiency, the “imprudence premium,” being reflected in the amount by which a fund’s AMVR score exceeds “1.0,” e.g., 1.50 indicates an imprudent premium of 50 basis points/50 percent. Estimated liability exposure and/or legal damages can then be calculated using the DOJ’s and GAO’s findings that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a 20-year period.22

In the example, the fund’s negative incremental return automatically makes the fund an imprudent choice relative to the comparable index fund. While some may want to argue difference in strategies and goals, ERISA focuses on the benefit provided to the plan participants. Whatever the active fund’s strategies and goals may have been, they ultimately were inferior in terms prudence, as the combined investment costs would have resulted in a loss of between $2.07 to $7.00 per share, compounded annually. The AMVR slide also shows that an investment in the active fund would have resulted in a plan participant suffering a projected 34 percent loss in end-return over a 20- period relative to the index fund option.

Going Forward
I believe the next 12-18 months are going to be a pivotal period in defining the future of 401(k)/403(b) litigation, both in terms of pleading standards and results. I believe the Matney could be the final piece of the puzzle.

The good news is that equitable and consistent results are easily attainable in 401(k)/403(b) litigation just by following the Restatement’s standards and SCOTUS’ decisions, as well as by simply applying some common sense, “humble arithmetic,” and fundamental fairness.

Notes
1. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022) (Matney)
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
3. Brief for the United States as Amicus Curiae, Hughes v. Northwestern University, United States Supreme Court, No. 19-1401.     
4. Restatement (Third) Trusts (American Law Institute) All rights reserved. (Restatement)
5. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022)
6. TriHealth, Ibid.
7. Matney, 14
8. Matney, 8
9. Matney, 8
10. Matney, 19
11. Tibble v. Edison International, 135 S. Ct 1823 (2015)
12. Albert v. Oshkosh Corp., 47 F.4th 570 (2022) (Oshkosh)
13. Oshkosh, 581
14. Hughes v. Northwestern University, No. 18-2569, March 23, 2023 (7th Cir. 2023) (Hughes), 11.
15. Hughes, 20
16. Hughes, 14
17. Hughes, 21
18. Hughes, 18-19
19. Hughes, 19
20. Matney, 8
21. Matney, 19
22. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess and Expenses,” (“DOL Study”); “Private Pensions: Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (“GAO Study”).

Copyright InvestSense, LLC 2023. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, consumer protection, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement planning, retirement plans, risk management, SCOTUS, SEC, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , | Leave a comment

1Q 2023 AMVR “Cheat Sheets”: How Much Active Management Do Actively Managed Funds Really Provide?

By James W. Watkins, J.D., CFP Board Emeritus™, AWMA®

The words that I remember
From my childhood still are true
That there’s none so blind
As those who will not see
– Justin Hayward/Moody Blues – “I Know You’re Out There Somewhere”

I know my reference to the Moody Blues will draw a chuckle from my friend, Robin Powell, leader of the evidence-based investing movement and owner of “The Evidence-Based Investor” blog (evidenceinvestors.com). We often joke about the fact that we may among the few that are still Moody Blues fans. But those lines still resonate with me because of the truth they tell, especially within the world of financial services and pensions plans.

The ongoing refusal of some to courts acknowledge SCOTUS’ recognition of the Restatement of Trusts as a legitimate resource in resolving disputes involving fiduciary issues is puzzling. More troubling is the fact that such refusal has resulted in the inequitable situation of the rights and guarantees promised by ERISA being decided on where one resides.

Fortunately, it appears that there may be hope on the horizon, hope that SCOTUS will have an opportunity to require that the legal system adhere to one consistent and equitable set of standards in deciding 401(k) and 403(b) litigation. That hope is the Matney v. Briggs Gold case1 currently pending in the Tenth Circuit of Appeals, a case that involves the two key issues that were involved in the Brotherston case2, namely the legitimacy of index funds as comparators in fiduciary prudence evaluations and the question of which party has the burden of proof regarding causation in 401(k)/403(b) actions.

The DOL recently weighed in on the burden of proof issue, stating that once the plan participants properly plead a breach of fiduciary duties, the plan sponsor should then have the burden of proof on the issue of causation, the burden of disproving the participants/ allegations, since they alone know what process they employed in making their decisions. The DOL cited the common law of trusts as a key factor in its position, just as the First Circuit Court of Appeals and the Solicitor General had done in Brotherston.

Once again, this past quarter’s Active Management Value Ratio (AMVR) “cheat sheets” clearly demonstrate why plan sponsors should closely monitor the progress of the Matney case. If ERISA plaintiff attorneys and the courts focus on the more meaningful factor of cost-efficiency rather than the antiquated and meaningless active/passive argument, I believe that plan sponsors will have an extremely difficult time carrying the burden of proof in proving that their decisions did not cause the resulting losses to the plan participants.

Once again, an actively managed fund’s AMVR score is calculated by dividing the fund’s incremental correlation-adjusted costs by its incremental risk-adjusted return. The costs and return calculations are based on comparisons to a comparable index

The AMVR slides shown above also show how the prudence/imprudence of an actively managed fund can quickly be determined by just answering two questions:

(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?
(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?

If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and unsuitable/imprudent according to the Restatement’s prudence standards and should be avoided. The goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental return), but equal or less than “1” (indicating that the fund’s incremental costs did not exceed the fund’s incremental return).

Is Active Management Much Ado About Nothing?
Some courts have consistently tried to justify the choice of various actively managed funds which would fail the AMVR’s fiduciary prudence test. Said courts have tried to justify underperformance based on factors such as investment strategies, goals and preserving choices for plan participants. My response is that if the purpose and goals of ERISA are to be honored and furthered, then the comparative performance of a fund and the comparative benefits provided to the plan participants are the true tests of a fund’s prudence. As for the “choices” argument, common sense says that a cost-inefficient mutual fund is never a legally viable “choice.”

In short, the actively managed fund had its chance to test its approach against a comparable index fund’s approach. More often than not, the actively managed loses. While a number of people took exception to Judge Kayatta’s suggestion in Brotherston that plan sponsors should choose index funds if they wish to avoid unnecessary liability exposure, he was simply telling the truth. Judge Kayatta’s position has been consistently supported by studies on the cost-efficiency of actively managed funds, studies with findings such as

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.3  

Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.4

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.5

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.6

Judge Kayatta’s position is further supported by John Langbein, who served as the Reporter on the committee that wrote the Restatement (Second) of Trusts over fifty years ago. Shortly after the release of the revised Restatement, Langbein wrote a law review article on the new Restatement. At the end of the article, he made a bold prediction:

When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.  

While all of these comments are true, they fail to address an even more fundamental question: How much active management do actively managed funds actually provide?

In a 2007 speech at the University of Pennsylvania Law School, Brian G. Cartwright, then general counsel of the SEC, asked this same question. Cartwright asked his audience to think of an investment in a mutual fund as a combination of two investments: a position in an “virtual” index fund designed to track the S&P 500 at a very low cost, and a position in a “virtual” hedge fund, taking long and short positions in various stocks. Added, together, the two virtual funds would yield the mutual fund’s real holdings. Cartwright told the students,

The presence of the virtual hedge fund is, of course, why you chose active management. If there were zero holdings in the virtual hedge fund — no overweightings or underweightings — then you would have only an index fund. Indications from the academic literature suggest in many cases the virtual hedge fund is far smaller than the virtual index fund. Which means…investors in some of these … are paying the costs of active management but getting instead something that looks a lot like an overpriced index fund. So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether or not they’re getting the desired bang for their buck?8


I would suggest that the AMVR provides such information. I would also suggest that combining the with Miller Active Expense Ratio (AER) provides an even more meaningful evaluation of the prudence/imprudence of an actively managed fund.

The AER determines the Active Weight (AW) within an actively managed fund, then uses the fund’s AW to recalculate the implicit expense ratio that investor in the fund is paying. Miller explained the importance of the AER, stating that

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.9

Using just a fund’s R-squared number and its incremental costs, Miller found that in terms of Active Weight, actively managed funds often provide very little active management, As a result, investors often pay an implicit expense ratio that is 300-400 percent, or even more, higher than the fund’s publicly stated expense ratio.

The slides above clearly show how the combination of a higher incremental cost and a high R-squared number result in a significantly higher AER. Under Miller’s metric, an R-squared of 98 equates to active weight of just 12.50 percent. I would suggest that referring to such a fund as “actively managed” might be questioned. One could also suggest that a refusal or failure to recognize and acknowledge such an inequitable situation constitutes “willful blindness” by a plan sponsor and an obvious breach of their fiduciary duties.

People often ask me why InvestSense uses the AER and correlation-adjusted costs in calculating a fund’s AMVR score. Simply because I believe that the AER provides a more accurate perspective of the costs an investor incurs. And as both the DOL and the GAO have stated, each additional 1 percent in fees/costs reduces an investor’s end-return by approximately 17 percent over a 20-year period10

Going Forward
In earlier posts, I had stated that I would announce a new metric, the “Fiduciary Prudence Score.” I shelved that metric, as some of my mentors suggested that it might confuse people and distract from the strength of the AMVR. Since I believe that the next 12-18 months are going to see a significant shift in the 401(k)/403(b) litigation arena, I do not want to do anything that would possibly detract from the simplicity and value of the AMVR.

If I am correct in my prediction for the next 12-18 months, plan sponsors should consider a fiduciary audit of their plan, an audit that uses both the AMVR and the AER as key fiduciary factors. When I meet with a prospective client, I suggest to them that they ask their current plan adviser to prepare an AMVR slide using exactly the same layout and criteria shown on the slides shown in this post. In most cases, the adviser has either totally refused to do so, or has made “improvements” to the AMVR calculation process. Once SCOTUS’ hears Matney and shifts the burden of proof on causation to plans, plan sponsors will belatedly realize the true value of the AMVR as a fiduciary risk management tool.

Notes
1. Matney v. Barrick Gold of North America, No. 4045 (10th Cir.)
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
3. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
4. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
5. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
6. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
7. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498
8.  SEC Speech: The Future of Securities Regulation: Philadelphia, Pennsylvania: October 24, 2007 (Brian G. Cartwright). http://www.sec.gov/news/speech/2007/spch102407bgc.htm
9. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926
10. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”). http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”).

Copyright InvestSense, LLC 2023. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investment advisers, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, risk management, SCOTUS, SEC, Supreme Court, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , | Leave a comment

“At the Pleading Stage”: An Analysis of the Seventh Circuit’s Reconsideration of Hughes v. Northwestern University

by James W. Watkins, III, J.D., CFP Board EmeritusTM AWMA® 

The Seventh Circuit’s recent decision1 in Hughes v. Northwestern University simply reinforces my opinion that there is definitely a trend going on in 401(k) and 403(b) litigation, a trend reinforcing both the spirit and the letter of the law with regard both ERISA and the Restatement of Trusts. As I have stated before, I believe the next 12-18 months is going to see a significant change in the 401(k) and 403(b) landscape, once that restores fundamental fairness in litigation involving such areas.

As a result, the prudent plan sponsor will perform an independent and objective analysis of their plan to determine the extent of any potential fiduciary liability exposure. I believe that most plan sponsors truly want to provide their employees with a meaningful retirement plan. Unfortunately, the evidence suggests that most plan sponsors fail to do so due to a lack of understanding as to what their fiduciary duties actually require and how to properly perform such duties. Fortunately, compliance with ERISA is relatively simple to accomplish and maintain.

When I review an ERISA decision, the first thing I ask is whether the decision is sustainable on appeal, whether it is consistent with both ERISA and the Restatement of Trusts. If not, then the decision arguably does nothing more than create a false sense of security for a plan sponsor. I think we have seen too many of such decisions.

However, I think the Seventh Circuit’s recent reconsideration of its earlier Hughes decision is a continuation of a trend which seems to be trying to establish a sense of fundamental fairness in 401(k)/403(b) litigation, most notably with regard to allowing plaintiffs to have some degree of discovery. Given ERISA’s focus on the fiduciary process used by a plan sponsor and the obvious fact that only the plan sponsor can know what that process was, any attempt by a court to require the plan participants to prove the flaws in such process without at least “controlled” discovery is inequitable.

The Sixth Circuit recognized that fact in its TriHealth decision, as Chief Judge Sutton suggested that too many 401(k) cases were being prematurely dismissed due to plaintiffs not being a chance at reasonable discovery.

But at the pleading stage, it is too early to make these judgment calls. ‘In the absence of further development of the facts, we have no basis for crediting one set of reasonable inferences over the other. Because either assessment is plausible, the Rules of Civil Procedure entitle [the three employees] to pursue [their imprudence] claim (at least with respect to this theory) to the next stage….’ 2

This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth ‘investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares’ because ‘the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….’ Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.3

Common sense supports this argument. If in fact the plan sponsors conducted the legally required objective and thorough independent investigation and evaluation of the funds selected for a plan, discovery could easily be limited to producing any and all materials used and relied on by the plan sponsor. The time and costs involved in such controlled discovery should be minimal. Then again, as the Sixth Circuit points out, such controlled discovery would also expose plan sponsors who did not comply with ERISA’s fiduciary requirements.  

The Seventh Circuit liberally cited from the Sixth Circuit’s TriHealth decision, pointing out that the plaintiff’s obligation to sufficiently plead its case is a separate and distinct obligation from proving causation. The Seventh Circuit’s consistent theme throughout the Hughes decision was on the concept of fundamental fairness to the parties and a balanced consideration of the facts.

“[P]laintiffs must have alleged enough facts to show that a prudent fiduciary would have taken steps to reduce fees and remove some imprudent investments.4

ERISA requires a fiduciary to assess whether a given fund is prudent in light of other investment options in a plan, comparable funds, and the expenses charged among other factors.5

Where alternative inferences are in equipoise-that is where they are all reasonable based on the facts, the plaintiff is to prevail in a motion to dismiss. (Citing TriHealth at 450), ‘Equally reasonable inferences…could exonerate[the plan sponsor]…[but] at the pleading stage, it is too early to make these judgment calls. This is because, at the pleading stage, we must accept all well-pleaded facts as true and draw reasonable inferences in the plaintiff’s favor.’6

A court’s role in evaluating pleadings is to decide whether the plaintiff’s allegations are plausible-not which side’s version is more probable. This, on a motion o dismiss, courts must give due regard to alternative explanations for an ERISA fiduciary’s conduct, but htye need not be overcome conclusively by the plaintiff.7

Another example of this “fundamental fairness” trend was evident in the Seventh Circuit’s Oshkosh decision, where the Court discredited the plan’s arguments that the expense ratios for the funds in the plan should be adjusted on a one-to-one basis to account for revenue sharing.

The problem is that the Form 5500 on which Albert relies does not require plans to disclose precisely where money from revenue sharing goes. Some revenue sharing proceeds go to the recordkeeper in the form of profits, and some go back to the investor, but there is not necessarily a one-to-one correlation such that revenue sharing always redounds to investors’ benefit. Albert’s ‘net investment expense to retirement plans theory’ assumes that there is such a correlation; if that assumption is wrong, then simply subtracting revenue sharing from the investment-management expense ratio does not equal the net fee that plan participants actually pay for investment management.8

The Hughes Decision and Cost-Inefficiency
As mentioned earlier, the Seventh Circuit specifically included cost as one factor that plan sponsors must consider in selecting investment options for their plan. The Court addressed this even further. stating that

[c]ost-conscious management is fundamental to prudence in the investment function, [and should be applied] not only in making investments but also in monitoring and reviewing investments.9 (citing RESTATEMENT (THIRD) OF TRUSTS Section 90, cmt. B, and Section 88, cmt. A)

Wasting beneficiaries’ money is imprudent.10 (citing UNIF. PRUDENT INVESTOR ACT SECTION 7, cmt. (UNIF. L. COMM”N 1995)

The Active Management Value Ratio (AMVR) could significantly help the parties and the courts properly evaluate the various claims and theories put forth in 401(k) and 403(b) litigation.

Reports and publications consistently rank the American Funds Growth Fund of America Fund (RGAGX) as one of the most common investment options within 401(k) and 403(b) plans. The following AMVR slide could help evaluate the fiduciary prudence of the fund.


Two things that immediately stand out on the AMVR slide:

1. RGAGX fails to provide a positive incremental return relative to the benchmark, the Vanguard Large Cap Growth Index Fund (VIGAX).
2. RGAGX has nominal incremental costs relative to VIGAX, without any commensurate return for such costs.

The DOL and the GAO have both stated that each additional 1 percent in fees/costs reduces an investor’s end-return by 17 percent over a twenty-year period.11 If we treat RGAGX’s relative underperformance (201 basis points) as an opportunity cost and combine such cost with RGAGX’s relative incremental cost (25 basis points), the projected reduction in end-return would be over 38 percent. I am not sure how a plan sponsor could successfully argue that causing an investor to suffer such a loss was a prudent investment choice when VIGAX was an available investment option.

Going Forward
I have previously stated that I believe that the next 12-18 months are going to be a pivotal period for the 401(k)/403(b) industry, for both plan sponsors and plan advisers. The combination of the currently emerging “fundamental fairness” trend within the courts and the simple and straightforward “Humble Arithemetic” evidence of the AMVR could prove difficult for plan sponsors to overcome if they wish to avoid unnecessary fiduciary liability exposure.

Those that follow me know that I believe that the final piece of the 401(k)/403(b) fiduciary prudence puzzle will be the Matney v. Barrick Gold of North America12 case (Matney). Matney is currently pending in the 10th Circuit Court of Appeals. Matney provides the legal system with an opportunity to resolve two ongoing ERISA issues, (1) the validity of the “apples and oranges” argument regarding comparison of actively managed mutual funds and index mutual funds, and (2) the question of who carries the burden of proof on the issue of causation.

Both of these issues were presented to SCOTUS in the Brotherston appeal in 2018. SCOTUS denied Purnam Investments’ petition for certiorari at that time. Matney gives SCOTUS another opportunity to resolve the two issues and end a split on the issues in the federal courts, guaranteeing employees an equitable and uniform standard of legal review in the courts.

Notes
1. Hughes v. Northwestern University, No. 18-2569, March 23, 2023 (7th Cir. 2023) Hughes)
2. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022)
3. TriHealth, Ibid.
4. Hughes, 17
5. Hughes, 11
6. Hughes, 19
7. Hughes, 20
8. Albert v. Oshkosh Corp., 47 F.4th 570, 581 (2022)
9. Hughes, 14
10. Hughes, 15
11. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”). http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”).
12. Matney v. Barrick Gold of North America, No. 4045 (10th Cir.)

Copyright InvestSense, LLC 2023. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, SCOTUS, Supreme Court | Tagged , , , , , , , , , , , , , | Leave a comment

“Humble Arithmetic” and the Future of 401(k) Litigation

By James W. Watkins, III, J.D., CFP Board EmeritusTM, AWMATM

Fortunately, there is currently a case pending in the 10th Circuit, the Matney case, which may go a long way in resolving two of the primary issues that continue to result in such inconsistent rulings. At the same time, I think a lot of the problems with ERISA cases could be avoided if the ERISA plaintiff attorneys and the courts would simply use what John Bogle referred to as “Humble Arithmetic.”

Several years ago I created a metric, the Active Management Value RatioTM 3.0 (AMVR). The AMVR is based on the research of investment icons such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel.

The AMVR allows plan sponsors and other investment fiduciaries, to quickly evaluate the cost-efficiency of an actively managed mutual fund. The legal system’s continued focus on the active/passive debate, rather than on the cost-inefficiency of most 401(k) investment options, is part of the current problem with ERISA litigation.

In Tibble, SCOTUS recognized the Restatement (Third) of Trusts (Restatement) as a legitimate resource in resolving fiduciary disputes, including questions regarding fiduciary duties under ERISA. The Restatement clearly recognizes the importance of cost-efficiency, stating that fiduciaries should carefully compare the costs associated with a fund, especially when considering funds with similar objectives and performance.1 The Restatement advises plan fiduciaries that in deciding between funds that are similar except for their costs, the fiduciary should only choose an active fund with higher costs and/or risks if

the course of action in question can reasonably be expected to compensate for its additional costs and risk,…2

Studies have shown that the public is more visually oriented than verbally oriented. The AMVR allows us to visually demonstrate the value of the Restatement’s position.

Burton L. Malkiel said that the best two predictors of future performance are a fund’s expense ratio and turnover, or trading costs.3 Mutual funds are not legally required to disclose their actual trading costs. However, recognizing the importance of such costs in analyzing the prudence of funds, John Bogle created a proxy that allows investors to factor in such costs in selecting mutual funds. Bogle’s proxy is simply to double a fund’s reported turnover ratio, and then multiply that number by 0.60. Under Bogle’s proxy, a fund with a turnover ratio of 25 percent would have estimated trading costs of 30 basis points, or 0.30 ( a basis point is equal to 1/100th of 1 percent).

For purposes of this post I want to compare the costs and performance of two actively managed mutual that are commonly found in 401(k) plans: Fidelity Contrafund Fund K shares (FCNKX) and T. Rowe Price Blue Chip Growth Fund R shares (RRBGX). The funds will be compared to the Vanguard Growth Index Fund Admiral shares (VIGAX).

First, a comparison of the funds based on the expense ratios and trading costs.

We’ll come back to this later. For now, just remember Bogle’s quote: “You get what you don’t pay for.”

The 5 and 10-year AMVR charts for FCNKX provide some interesting insights.

The 5-year AMVR slide shows that FCNKX is an imprudent investment choice relative to VIGAX based on the fact that
(1) FCNKX fails to provide a positive incremental return relative to VIGAX, and
(2) FCNKX’s incremental costs (0.42) obviously exceeds FCNKX’s negative incremental return.

The 10-year AMVR slide shows that FCNKX is arguably prudent investment choice relative to VIGAX based on the fact that
(1) FCNKX provides a positive incremental return relative to VIGAX, and
(2) FCNKX’s positive incremental return (0.81) exceeds FCNKX’x incremental costs (0.42).

But is it possible that looks could be deceiving, that other factors need to be considered to gain a more accurate evaluation of FCNRX relative prudence?

Ross Miller created a metric, the Active Expense Ratio (AER), that factor in rhe correlation of returns between two funds. If an actively managed fund’s returns are highly correlated to the less-expensive index fund, one should question how much active management the actively managed fund actually provided. Are investors getting a fair return on their investment in terms of cost-efficiency.

Miller explained the value of the AER as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.3

In the two AMVR slides. the “AER” column provides an interesting insight into the prudence of FCNKX. The correlation of returns between FCNKX and VIGAX was extremely high over the time period in question, 98 percent. As a result, the actual active value contribution for FCNKX was estimated to be approximately 12.5 percent, resulting in much higher, 6-7 times higher, implicit expense ratio over each time period. Based on these findings, one can argue that FCNKX was actually an imprudent investment option relative to VIGAX for 401(k) plans and other investment fiduciaries, as well as for investors in general.

The AMVR slide for RRBGX provides an even more compelling reason for factoring in an actively managed fund’s AER.

From what I have been able to tell, to date no court or attorney has utilized such a cost-efficiency process to evaluate the fiduciary prudence of investment options. The actual calculation process is extremely simple and straightforward. I have actually had occasion to do the calculations on a napkin using my cell phone. So, if ERISA’s original purpose and goals are to be realized, I have to wonder why the process described herein have not been at least explored and argued.

The argument becomes even more compelling if we incorporate the findings from Malkiel’s performance predictors. Malkiel’s theory definitely held true in our examples, especially when the AEWR was considered.

I often use a RRBGX AMVR slide to show just how damaging the combination of high expense ratios and a high correlation of returns between an actively managed funds and a comparable index fund can have on fiduciary prudence realized returns. The correlation between RRBGX and VIGAX was 98. While the 10-year AMVR slide showed improvement, RRBGX still failed to produce a positive incremental return

Going Forward
I believe that recent developments suggest that significant changes are coming in 401(k) and 403(b) litigation. One of the key unresolved issues involves which party has the burden of proof on the issue of causation in ERISA 401(k) litigation. The DOL recently filed an amicus brief in the Home Depot 401(k) litigation in the 11th Circuit. The DOL’s amicus brief supports the position of the common law of trusts, the First Circuit Court of Appeals’ and the Solicitor General position that the plan sponsor has that burden. As the AMVR slides herein suggest, that burden may prove a difficult one to carry in most cases if SCOTUS adopts that position as well.

Notes
1. Restatement (Third) Trusts (American Law Institute) All rights reserved. (Restatement)
2. Restatement, Section 90, comment h(2)
3. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926

Copyright InvestSense, LLC 2023. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.


Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, risk management | Tagged , , , , , , , , , , , , | Leave a comment

401(k) InvestSense: Focus on Fiduciary Process Over Product

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

People often ask me what is the most common mistake that plan sponsors make, The answer is simple-assuming unnecessary fiduciary liability exposure by focusing on product rather than process. Actually, that answer applies to investment fiduciaries in general.

The courts have recognized that ERISA is essentially the codification of the common law of trusts, which in turn sets out various standards of conduct for fiduciaries. Part of the problem is that few plan sponsors have ever read or talked with an ERISA attorney about ERISA or the applicable standards. Too many plan sponsors have simply chosen to blindly follow the advice of conflicted third parties, such as mutual funds and insurance/annuity salesmen.

The courts have warned plan sponsors that reliance on third parties must be both reasonable and justified. As the court shave warned plan sponsors, reliance on commissioned sales people is rarely reasonable or justified due to the inherent conflict of interests that exists with such advisers.

We have explained that the fiduciary duties enumerated in § 404(a)(1) have three components. The first element is a “duty of loyalty” pursuant to which “all decisions regarding an ERISA plan `must be made with an eye single to the interests of the participants and beneficiaries.'” Second, ERISA imposes a “prudent man” obligation, which is “an unwavering duty” to act both “as a prudent person would act in a similar situation” and “with single-minded devotion” to those same plan participants and beneficiaries.1

Finally, an ERISA fiduciary must “`act for the exclusive purpose'” of providing benefits to plan beneficiaries.2

“[T]he duties charged to an ERISA fiduciary are `the highest known to the law.'” When enforcing these important responsibilities, we “focus[] not only on the merits of the transaction, but also on the thoroughness of the investigation into the merits of the transaction.”’3

One extremely important factor is whether the expert advisor truly offers independent and impartial advice.4 

FPA and Pescitelli, therefore, are not independent analysts. FPA does not work for TWU; rather, insurance companies like Transamerica pay Pescitelli’s salary. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best. A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative. FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce. 841-842  5

So, what does ERISA actually say with regard to the fiduciary duties of a plan sponsor? Section 404(a) of ERISA provides that

(a) a fiduciary shall discharge that person’s duties with respect to the plan solely in the interests of the participants and beneficiaries; for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the plan; and with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.

(b) Investment prudence duties.

(1) With regard to the consideration of an investment or investment course of action taken by a fiduciary of an employee benefit plan pursuant to the fiduciary’s investment duties, the requirements of section 404(a)(1)(B) of the Act set forth in paragraph (a) of this section are satisfied if the fiduciary:

(i) Has given appropriate consideration to those facts and circumstances that, given the scope of such fiduciary’s investment duties, the fiduciary knows or should know are relevant to the particular investment or investment course of action involved, including the role the investment or investment course of action plays in that portion of the plan’s investment portfolio or menu with respect to which the fiduciary has investment duties; and

(ii) Has acted accordingly.

(2) For purposes of paragraph (b)(1) of this section, “appropriate consideration” shall include, but is not necessarily limited to:

(i) A determination by the fiduciary that the particular investment or investment course of action is reasonably designed, as part of the portfolio (or, where applicable, that portion of the plan portfolio with respect to which the fiduciary has investment duties) or menu, to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action compared to the opportunity for gain (or other return) associated with reasonably available alternatives with similar risks; 

(c) Investment loyalty duties.

(1) A fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote benefits or goals unrelated to interests of the participants and beneficiaries in their retirement income or financial benefits under the plan.

(2) If a fiduciary prudently concludes that competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon, the fiduciary is not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns. A fiduciary may not, however, accept expected reduced returns or greater risks to secure such additional benefits. 6

So, where do plan sponsors usually get in trouble with regard to such legal obligations?

“[W]ith the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

First, notice that Section 404(a)does not expressly require that a plan offer any specific investment within a plan. As is the case with most laws and regulations, ERISA is written in broad general terms in order to provide regulators with maximum flexibility to address violations on an “as needed” basis.

With the passage of SECURE and SECURE 2.0, I have been receiving calls and emails from both InvestSense clients and non-clients saying that annuity representatives have been falsely telling them that both SECURE acts require plans to offer annuities within their 401(k) plans. Simply not true. Same goes for crypto.

I have even had annuity and crypto advocates tell me that is morally wrong not to offer such investments in a plan if the plan participants wish to invest in such investments. Morally wrong…seriously?

I have been involved in fiduciary law in one way or the other since 1996. I have advised fiduciaries to use the same two question fiduciary risk management technique that I use in performing forensic analyses of actively managed funds.

1. Does ERISA expressly require that the specific investment be offered within a 401(k) or 403(b) plan? From the previous discussion, we know the answer to that question will always be “no.”
2. Would/Could inclusion of the specific investment in the plan potentially result in unnecessary fiduciary liability exposure for the plan sponsor?

The second question requires an analysis of an investment pursuant to ERISA’s prudent person standard. I am often asked to provide expert analyses with regard to actively managed mutual funds and, recently, annuities. The proper question is whether a plan sponsor’s investment selections measure up under ERISA’s prudent person standard, from a process versus product viewpoint.

Actively Managed Mutual Funds
The cornerstone of my analysis of actively managed mutual funds is based on my metric, the Active Management Value Ratio (AMVR). The AMVR is simply a modified version of the well-known cost/benefit metric commonly used in numerous businesses and professions.

In this case, the AMVR is simply a visual presentation of the research of investment experts such as Nobel Laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton G. Malkiel.

[T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.7

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns.

When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns! 8

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover. 9  

These three opinions formed the basis for the initial iteration of the AMVR. Further research led to the current version of the AMVR – AMVR 3.0 – which incorporates the research of Ross Miller and his Active Expense Ratio (AER) metric. Miller explains the importance of the AER as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.10

An example of the end result – AMVR 3.0 – is shown below.

An AMVR analysis can be calculated for any time period. In this case, a five-year analysis comparing an actively managed fund and a comparable index fund shows that the actively managed fund is cost-inefficient, as it fails to provide a positive incremental return (1.33), so naturally the incremental costs exceed the incremental returns. A cost-inefficient fund is an imprudent investment under the Restatement (Third) of Trusts.

The cost-inefficiency in the example is even more serious if measured using the AER, In this case, the high incremental costs of the funds combined with the fund’s high correlation of return to the benchmark (98) results in an AER of 5.67.

The example show above is far from an anomaly. Research has consistently shown that the overwhelming majority of actively managed funds are cost-inefficient.


99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.11  

Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.12

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.13

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.14

Perhaps the best advice on selection of mutual funds was offered by John Langbein, who served as the Reporter on the committee that wrote the Restatement (Second) of Trusts over fifty years ago. Shortly after the release of the revised Restatement, Langbein wrote a law review article on the new Restatement. At the end of the article, he made a bold prediction:

When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.15   

The AMVR provides a quick and simple process that plan sponsors can uses to reduce their risk of unnecessary and unwanted fiduciary liability exposure by ensuring the prudence of their investment choices of their plan.

Annuities
The current attempt to convince plan sponsors to include annuities inn their plans is a perfect example of the psychological tactic known as “framing.” Framing refers to how an idea is presented in order to convince someone to agree with idea.

In the case of annuities, the pitch is “guaranteed income.” However, that hardly presents all of the variables that a plan sponsor needs to consider before deciding to include annuities in their 401(k) or 403(b) plan. As usual, the devil is in the details. As the late insurance advisor Peter Katt used to warn, “at what cost?”

Key risks with annuities include excessive fees, purchasing power risk, the risk that inflation will reduce the value of annuity payments, and single equity credit risk, the risk that the annuity issuer will not be able to make the payments called for by the annuity contract. Chris Tobe, one of the co-founders of otherthis blog’s sister site, the CommonSense 401(k) Project has written some excellent posts explaining some of the risks inherent in annuities. I highly recommend that you review his posts.

And with annuities, there are other serious costs that fiduciaries have to consider, most notably the commensurate return/windfall issue If the annuity requires that the annuity owner “annuitize” the annuity contract in order to receive the promised benefit of “guaranteed income,” the annuity owner has to surrender control of both the annuity and its accumulated value, with no guarantee of a commensurate return for the surrendered value, creating the potential windfall for the annuity issuer at the expense of the annuity owner and their heirs.

Plan sponsors often overlook the potential fiduciary liability issues created by the commensurate return/windfall issue. Fiduciary law is a combination of trust law, agency law and the law of equity. A basic tenet of equity law is that “equity abhors a windfall

Annuity advocates usually respond to the commensurate return issue by pointing out that some annuities address such shortcomings by offering the annuity owner a rider that guarantees the return of the premiums they paid…for yet another fee. Studies by both the Department of Labor and the General Accountability Office have stated that each additional 1 percent in fees/costs reduced an investor’s end-return by approximately 17 percent over a period of twenty years.16 So, the recommendation to “just add a rider” is not a simple solution to the commensurate return issue.

While these issues present obvious potential fiduciary liability concerns for plan sponsors, there is a simple way to avoid them altogether. Remember, ERISA does not require that a plan offer any specific investment within a plan. Given the potential fiduciary liability issues discussed herein, we advise our clients not to offer annuities within their plan.

ERISA does not require plan participants to assume unnecessary fiduciary liability risk. Annuities are often complex and confusing. For example, “indexed” annuities deliberately mislead investors into believing that they may achieve the returns of a market index. However, they quickly learn that the annuity issuer will significantly reduce their actual realized return by imposing restrictions such as caps on return and “participation rates.” Artificial and arbitrary restrictions and the various methods of computing and crediting returns simply increase the potential for fiduciary mistakes/misunderstandings and, thus, the potential for increased fiduciary liability exposure. Plan participants that wish to invest in annuities would still be free to do so outside the plan.

Going Forward
Far too often, plan sponsors and other investment fiduciaries unknowingly assume unnecessary and unwanted fiduciary liability exposure. This mistake is often due to a lack of knowledge and understanding as to what ERISA or trust law requires of them.

Hopefully, this post has helped plan sponsors and other investment fiduciaries realize how simple ERISA and fiduciary compliance can be by focusing on fiduciary process rather than investment products. An ERISA compliant fiduciary process will both simplify the selection of investment options and help reduce fiduciary liability exposure by ensuring the selection of prudent investment products.

Hopefully, this post has also convinced the reader to further explore the AMVR metric and learn how simple it is to use the AMVR to

> reduce potential fiduciary liability exposure,
> improve the quality of plan investment options.
> potentially simplify their plan in order to reduce administrative costs and increase employee > participation in the plan.

Bottom line-A proper fiduciary process will help ensure the prudence of the plan’s investment options.

.Notes
1. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003).
2. Gregg, Ibid.
3. Gregg, Ibid.
4. Gregg, Ibid.
5. Gregg, Ibid.
6. 29 C.F.R. § 2550.404-1; 29 U.S.C. § 1104(a)
7. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm
8. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
9. Burton G. Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
10. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926
11. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANE 179, 181 (2010)
12. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8e
13. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997)
14. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016
15. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498
16. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”). http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”),

Copyright InvestSense, LLC 2023. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, Annuities, best interest, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investment advisers, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, risk management, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , | Leave a comment

Brotherston Revisited: Will the 10th Circuit Court of Appeals “Fix” the Ongoing 401(k) SNAFU?

“Facts do not cease to exist because they are ignored” – Aldous Huxley 

In 2018, the First Circuit handed down its decision in Brotherston v. Putnam Investments, LLC.1 The decision is arguably the best analysis of the applicable fiduciary standards in 401(k) litigation. Among the court’s best points: 

The Restatement calls “for determining whether and in what amount the breach has caused a `loss’ . . . by reference to what the results `would have been if the portion of the trust affected by the breach had been properly administered.’”2  

Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes “return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).”3 (citing § 100 cmt. b(1) 

ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for “any losses to the plan resulting from each such breach.” Certainly this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent “to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.”4 (cjtes omitted) 

And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts. (citing Varity Corp. v. Howe, 516 U.S. 489, 496-97, 502, 506-07 (1996) (relying on “ordinary trust law principles” to fill gaps created by ERISA’s lack of definition regarding the scope of fiduciary conduct and duties).5

[T]he burden of showing that a loss would have occurred even had the fiduciary acted prudently falls on the imprudent fiduciary. By allowing its analysis on loss to be driven by its concern regarding the objective prudence of the Putnam funds, the district court in essence required plaintiffs to show causation as part of its case on loss-even as it correctly sought to reserve that requirement to defendants.6 

So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes).7

In concluding, Judge Kayatta made two significant points: 

The Supreme Court has time and again adopted ordinary trust law principles to construe ERISA in the absence of explicit textual direction.8 

[T]he Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits…. In other words, Congress sought to offer beneficiaries, not fiduciaries, more protection than they had at common law, albeit while still paying heed to the counterproductive effects of complexity and litigation risk.9 

Putnam applied for certiorari so SCOTUS would review the First Circuit’s decision. SCOTUS invited the Solicitor General to file an amicus brief with the Court, which it eventually. While the Solicitor General agreed with both the First Circuit’s decision and its reasoning behind the decision, the Solicitor General advised the Court not to grant cert since Putnam’s application since it was technically an interlocutory appeal, meaning the case was still ongoing. SCOTUS ultimately denied Putnam’s request for review. 

Post-Brotherston 401(k) Litigation 
While both SCOTUS’ and the Solicitor General’s decisions are understandable, it still left left a significant void in 401(k) litigation, one that has arguably resulted in questionable and inconsistent interpretations of ERISA and unnecessary harm to 401(k) plan participants. At a time when the public’s perception of the American legal system is at one of its all-time lows, plan participants are openly questioning why courts can have such divergent interpretations on the same piece of legislation, knowing the harmful impact that such inconsistencies have created. 

ERISA plaintiff’s attorneys have the same question in light of SCOTUS’ decision in Tibble v. Edison International. In Tibble10, SCOTUS specifically noted that the courts often turn to the Restatement for guidance in resolving questions involving fiduciary law, including questions involving ERISA. 

Some have tried to dismiss the 401(k) cases filed as nothing more than “Monday-morning quarterbacking,” complaints about the ultimate performance of a plan’s investment options. That complaint rings hollow for several reasons. First, neither financial advisors nor plan sponsors are generally held liable for the ultimate performance of their recommendations/selections, as neither can control the performance of the financial markets. Second, ERISA claims of fiduciary imprudence are based on the prudence of a plan sponsor’s investment decisions as of the time such decisions were made. 

Despite SCOTUS’ endorsement of the Restatement as a resource in ERISA cases, some courts continue to refuse to accept the objective and equitable established by the Restatement. As the First Circuit noted, Section 100 of the Restatement expressly approves of the use of comparable index funds as comparators in 401(k) litigation. Yet, numerous courts continue to dismiss 401(k) actions using index funds, describing them as “unacceptable comparators” and as trying to compare “apples and oranges.” 

The fact that SCOTUS passed on the opportunity to expose the disingenuousness of the “apples and oranges” argument is especially troubling. As the First Circuit pointed out, the Restatement’s support for index funds establishes that denial of the use of index funds based solely on the active/passive characterization has no merit.  

That said, the Restatement does condition the use of index funds as comparators to comparable index funds. Some courts have seized upon this requirement to argue that actively managed funds may have different strategies and/or different goals that resuklt in the extra costs and extra risks typically associated with actively managed funds and active strategies. 

Said court rarely address the other side of argument, the fact that the ultimate goal of ERISA and its stated purpose is to provide for and protect the plan participants’ best interests. An actively managed plan has the same opportunity as a comparable index fund to meet such goals. If the actively managed fund fails to do so, the fact remains that a plan participant is better served by the comparable index fund. 

Facts are stubborn things. Studies have consistently established that the overwhelming majority of actively managed mutual funds are not cost-efficient relative to comparable index funds. 

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.10 
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.11 
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.12 
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.13 

Furthermore, as some courts try to justify the use of cost-inefficient active funds in 401(k) plans, an often-unaddressed issue involves the fundamental issue of just how much active management do “actively” managed funds, both in terms of absolute return, i.e., “closet indexing,” and cost-efficiency.  

Closet indexing is an international issue that continues to demand additional attention…except in the U.S. The financial implications of closet indexing for investors are well-known.  

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….14 

The issue of closet indexing was a key issue in the Caterpillar 401(k) case.15 Closet indexing was a significant factor in the plaintiffs’ ability to defeat a motion to dismiss, which quickly led to a settlement of the action. 

Costs matter. When the Securities and Exchange Commission (SEC) announced and implemented Regulation “Best Interest” (Reg BI), then SEC chairman Jay Clayton acknowledged the importance of cost-efficiency of investments: 

rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes utility.16  

[A]n efficient investment strategy may depend on the investor’s utility from consumption, including…(4) the cost to the investor of implementing the strategy.17  

The situation becomes even worse if the costs are adjusted for the correlation between the active suite funds and the comparable index funds, shown here based on Miller’s Active Expense Ratio (AER). Miller described the importance of the AER: 

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.18 

The fact that more ERISA plaintiff’s attorneys do not incorporate a closet indexing claim into their complaints is surprising to me, especially given its proven effectiveness and available research. An additional arrow in one’s quiver can never hurt.

Brotherston Revisited in the 10th Circuit? 
Could the frustrations resulting from SCOTUS’ refusal grant cert in Brotherston and the ongoing misinterpretations of ERISA and unnecessary harm to plan participants potentnially be coming to an end?  
 
A case is currently pending in the 10th Circuit Court of Appeals involves many of the same issues that were in Brotherston, specifically the “apples and oranges” argument and the issue of whose has the burden of proving causation in 401(k) actions.19 The district court ruled against the plan participants on both questions and dismissed the action.  

The questions before the Court have already been addressed herein. However, an amicus brief filed with the Court deserves special mention. One argument raised by the amicus brief was that the plaintiffs failed to establish the imprudence of the process used by the plan sponsors. The brief conveniently fails to mention that the plaintiffs were never provided to learn of the process used, as no discovery had been allowed. Without discovery, any argument would have been pure speculation.  

This case is a perfect example of how some courts are improperly confusing the two distinct stages of pleading and proof of causation.  The First Circuit noted the impropriety of combining the two stages for the purpose of prematurely dismissing meritorious 401(k) actions.  

Some courts have attempted to justify combining the two stages by alleging the costs of discovery if plan participants are permitted to have discovery. The amicus brief made a similar argument. Fortunately, the Sixth Circuit recently exposed the lack of legal merit to such arguments and premature dismissals based on same. 

This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth ‘investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares’ because ‘the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….’ Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.20 

Common sense supports this argument. If in fact the plan sponsors conducted the legally required objective and thorough independent investigation and evaluation of the funds selected for a plan, discovery could easily be limited to producing any and all materials used and relied on by the plan sponsor. The time and costs involved in such controlled discovery should be minimal. Then again, as the Sixth Circuit points out, such controlled discovery would also expose plan sponsors who did not comply with ERISA’s fiduciary requirements.  

Going Forward 
The unresolved issues from Brotherston need to be addressed and resolved in order that the federal courts operate under a universal and consistent interpretation of ERISA in enforcing the rights and protections guaranteed under ERISA. The 10th Circuit will have the opportunity to do so. If they fail to do so, one can only hope that SCOTUS will be given an opportunity to revisit Brotherston and the Solicitor General’s excellent analysis of fiduciary law and ERISA.

Notes 
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
2. Brotherston, 31.
3. Brotherston, 31.
4. Brotherston, 31.
5. Brotherston, 33.
6. Brotherston, 34.
7. Brotherston, 36.
8. Brotherston, 36.
9. Brotherston, 37.
10. Tibble v. Edison International, 135 S. Ct 1823 (2015).
11.Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
12. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
13. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
14. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
15. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What They Pay For?:The Legal Consequences of Closet Index Fundshttps://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133 (Cremers), 5, 42.
16. Martin v. Caterpillar, Inc., (not reported) 2008 WL 5082981 (C.D. Ill. 2008), 453,
17. SEC Release 34-86031, “Regulation Best Interest: The Broker-Dealer Standard of Conduct” (Reg BI), 279. (2020)
18. Reg BI, 279.
19.  Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
20. Matney v. Barrick Gold of N. Am., Inc. 2022 WL 1186532 (D.Ut. April 21, 2022)
21. Forman v. TriHealth, Inc., 40 F.4th 443, 453 (2022).

Copyright InvestSense, LLC 2023. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, Reg BI, retirement planning, retirement plans, SCOTUS, Supreme Court | Tagged , , , , , , , , , , , , , , , | Leave a comment

4Q 2022 AMVR “Cheat Sheets”: Correlation of Returns, “Closet Indexing,” and Fiduciary Liability

James W. Watkins, III, J.D., CFP Board EmeritusTM, AWMATM

First, note the new URL address. After years of having to explain the old “iainsight.wordpress.com” URL, we finally worked with WordPress to accomplish the re-branding. Kudos to WordPress for working with us and for their patience in helping us to accomplish the “fiduciaryinvestsense.com” re-branding and increase the InvestSense franchise.

Now, as for the “cheat sheets,” no real surprises here, as the six non-index-based funds in “Pensions & Investments” annual survey of the top mutual funds in U.S. defined contribution plans, based on total investment by plan participants, remain the same.

Just a reminder, InvestSense provides information based on the funds’ nominal numbers, or public reported performance numbers. These are the numbers see in the public ads and reports.

InvestSense uses the risk-adjusted returns (RAR) and correlation-adjusted costs numbers (CAC), as those numbers provide a more accurate picture of performance and costs. We advise plan sponsors, trustees and other investment fiduciaries, as well as attrorneys, to do the same for that reason as well.

None of the six funds qualified for an AMVR rating using either the nominal or adjusted numbers, as none were able to produce a scenario where the active fund’s incremental costs exceeded its incremental returns. Only two were even able to outperform a comparable Vanguard index fund.

Same story when analyzing the 10-year numbers. None of the six funds qualified for an AMVR rating using either the nominal or adjusted numbers, as none were able to produce a scenario where the active fund’s incremental costs exceeded its incremental returns. Only three were even able to outperform a comparable Vanguard index fund.

However, both charts provide a potentially significant lesson in connection with fiduciary risk management. Note the significant increase in effective incremental costs (AER column) for both Fidelity Contrafund and T. Rowe Price Blue Chip Growth when correlation of returns is factored in. Actively managed funds with a combination of high nominal incremental costs and a high r-squared. correlation of returns, number can expect to see similar high CACs and a failure to qualify as prudent investment options under AMVR standards.

Active Expense Ratio and Closet Indexing
I recently posted an article addressing the issue of closet and the poor response of the United States in general general in addressing the issue when compared to the response of other countries in recognizing and addressing both the issue and its negative impact on investors.

The AMVR uses Miller’s Active Expense Ratio (AER) to help expose potential cases of closet-indexing and evaluate the negative impact on 401(k) and 403(b) plan participants. People often ask me why we even calculate AER. Miller explained the value of the AER as follows

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.1

The AER supports Miller’s claim that the performance of most actively managed funds is overwhelmingly attributable to the it’s benchmark rather than the fund’s active management team. Part of the AER’s methodology requires that the user calculate the Active Weight (AW) of the mutual fund, the percentage of actual management provided by the active fund.

To calculate an actively managed fund’s AW only requires two pieces of data, the active fund’s correlation of returns to the comparable index fund and the fund’s incremental returns. For example, Contrafunds incremental cost is 69 basis point. (basis points is a term commonly used in the financial world. You do not need to understand it in calculating AW or AER.)

Contrafund’s r-squared, or correlation of returns0 number is 98 out of a possible 100. AW is then calculated as follows:

AW = SQRT(1 minus R-squared)/[(SQRT(R-squared) + (SQRT(1 minus R-squared.)]

Using our data, Contrafund’s AW is .1250, or an active weight of only 12.50%. Wonder how investors would react if they are only getting 12.50% of actual active management while actually underperforming the less expensive index funds and paying a fee approximately thirteen times higher for the privilege of receiving such underperformance.

To calculate an actively managed fund’s AER, simply divide the fund’s incremental costs by the fund’s AER. Here, Contrafund’s AER would equal 5.52 (0.69/.1250). Such a significant difference in the fund’s implicit expense ratio drastically reduces the fund’s relative cost-efficiency.

A high r-squared number is often a sign of a possible closet index fund. So why is so much international discussion and concern over closet-indexing? Martijn Cremers, co-creator of the Active Share metric, explains the reason for such concern.

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….2

So should U.S. investors be concerned about possible closet-indexers? Most U.S. domestic equity-based funds are reporting r-squared of 90 or above, with many of the best-known funds reporting r-squared number of 95 and above. Both the 5 and 10-year cheat sheets demonstrate that trend.

The AMVR and Fiduciary Prudence: A One-Act Pla
y
I love working with my fiduciary risk management clients. During an initial meeting with a perspective client, I make my presentation using the famous InvestSense Fiduciary Liability Circle and several AMVR forensic analysis charts.

I often use an AMVR slide analyzing Fidelity Contrafund K shares since they are a common investment option within 401(k) and 403(b) plans.

I ask three simple questions:

1. Did the actively managed fund provide a positive incremental return, i.e., outperform the benchmark?
2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs?
3. In accordance with the Restatement of Trusts’ Prudent Investor Rule (PIR), did the actively managed fund provide the highest level of return for the lowest level of costs and risks or, in the alternative, the lowest level of risk and costs for a given level of return?

If the answer to any of the three questions is “no,” then the actively managed is imprudent relative to the benchmark under the PIR standards. A quick check of the answers using the fund’s AER will often suggest that the fund may qualify as a imprudent closet-index fund.

At some point, the results of the three-question test usually results in something similar to the following scenario:

CEO: So, we are paying annual costs that are 8-10 times higher than the comparable index fund and essentially getting no commensurate return for the extra costs and risks of the actively managed fund? Why are we invested in this fund?
Investment Committee Member: Because our plan adviser recommended the fund.
CEO: Then why are we paying the plan adviser for such poor advice?
Investment Committee Member: They were highly recommended.
CEO: Just how much are we paying the plan adviser?
Investment Committee Member: $$$$$$$$$$$$$$$$$
CEO: Mr. Watkins, can we sue them?
Me: Yes and no. You agreed to a fiduciary disclaimer clause in the advisory contract, so they arguably have no fiducairy duty to you, the plan, or the plan participants. That said, the Supreme Court has ruled that you may be able to sue them based on common law grounds such as negligence, breach of contract and fraud.

At that point, the CEO asks how much potentially liability exposure they have and what their options are to address/”fix” the situation.

The SEC, Finra and the DOL have essentially buried their heads in the sand and have avoided discussing both the topic of closet-indexing and its harmful effects on plan participants. While there may not be any universally accepted standards for categorizing a fund as a closet-index fund, the quantitative analysis provided by an AMVR analysis can provide numbers reflecting the damage being inflicted on both plan participants and investors in general.

Notes

1. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
2. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133 (Cremers), 5, 42.

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This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought

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