Avoiding ERISA’s #1 Fiduciary Liability “Gotcha”

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

Fiduciary law is a combination of trust and agency law. The basic rule of fiduciary law is that a fiduciary must always put their customer’s/client’s best interests first.

There are certain duties that are fundamental to fiduciary law. The two primary duties are the duty of loyalty and the duty of prudence. The duty of loyalty simply relates to a fiduciary’s duty to always put a customer’s/client’s best interests first. In describing the duty of prudence, the Section 90 of the Restatement (Third) Trusts (aka the Prudent Investor Rule) (Rule) states that

“[t]he [fiduciary] is under a duty to the [customers/clients] to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust. This standard requires the exercise of reasonable care, skill, and caution,…

ERISA Section 404(a) sets out an ERISA fiduciary’s duties, including the same standards of care set out in the Rule, as well as a duty to act solely in the interests of the plan’s participants and beneficiaries and a duty to control the plan’s costs

Many 401(k) plans attempt to qualify as a 404(c) in order to shift the risk of investment returns to the plan’s participants. However, Fred Reish,  one of the nations’s most respected ERISA attorneys, shares the opinion of many ERISA experts that most 401(k)/404(c) plans are not ERISA compliant, and thus face potentially severe consequences.

[O]ur experience is that very few plans actually comply with 404(c). It is probable that most (perhaps as high as 90%) 401(k) plans do not comply with 404(c) and, as a result the fiduciaries of those plans are personally responsible for the prudence of the investment decisions made by participants.

[E]ven if a plan complies with the 404(c) requirements, the pressure is not taken off the fiduciaries. Fiduciaries have a legal obligation to offer investments that are ‘suitable and prudent.’ (1)

Most of the current litigation involving 401(k) plans involves questions about the appropriateness of the of investment options offered within a plan, particularly the fairness of the fees associated with the plan’s investment options, many of which are actively managed mutual funds. Many critics of 404(k) plans point out that plan participants could receive the same, or in many cases, even better returns through the use of less expensive index funds. Many investment professionals complain about the attention given to the fees associated with the plan’s investment options, claiming that it overlooks the benefits provided to plan participants in exchange for an investment’s higher fees.

They say a good attorney can argue both sides of a case. Therefore, as an attorney, I look for evidence supporting arguments on both sides and then weigh the persuasiveness of all of the evidence. For that reason, each your I perform a forensic analysis of the top ten mutual funds used in American defined contribution, as reported each September by “Pensions & Investments” magazine. “Pensions & Investments” is purely objective, as their list is not a subjective ranking, but rather a list based on the cumulative amounts invested in each fund within the defined contribution industry.

I recently posted the new 2015 ERISA Fiduciary Prudence Analysis (Analysis) online at Slideshare. You can find the analysis here. The cornerstone of the analysis is my proprietary metric, the Active Management Value Ratio™ (AMVR). While the AMVR is simple to calculate, requiring only the ability to add, subtract and divide, it provides a clear picture of the benefits, if any, of the incremental, or additional, costs charged by actively managed mutual funds.

The AMVR metric will provide one of three results: (1) that the actively managed mutual fund provides no incremental, or added, benefit for an investor; (2) that the actively managed mutual fund provides an incremental, or added, benefit for an investor, but the incremental cost exceeds the incremental benefit; or (3) that the actively managed mutual fund provides an incremental, or added, benefit for an investor, and the incremental benefit is greater than the incremental cost. Results (1) and (2) are obviously problematic from a fiduciary liability viewpoint, as both result in an investor actually losing money from the investment.

The rules for fiduciary investing are set out in the Prudent Investor Rule (Rule), Section 90 of the Restatement (Third) Trusts and the Uniform Prudent Investor Act (Act), which simply codifies the Rule. Section 7 of the Act, and the comment thereto, makes the Act’s position on investment costs very clear

In investing and managing [account] assets, a trustee may only incur costs that are appropriate and reasonable and reasonable in relation to the assets, the purposes of the trust, and the skills of the [fiduciary].

Wasting [customers’/clients’] money is imprudent. In devising and implementing strategies for the investment and management of [account] assets, [fiduciaries] are obliged to minimize costs.

The Act cites the Restatement (Second) Trusts in support of its position and states that

[I]t is important for [fiduciaries] to make careful cost comparisons, particularly among similar products of a specific type being considered for a [fiduciary] portfolio. 

Again, since results (1) and (2) from the AMVR require investors to pay an additional amount without receiving a commensurate return, it is clear that they would be imprudent. Remember, fiduciary prudence is determined not on an investment’s eventual performance, but rather on the prudence of process that the fiduciary used in selecting the investments for an account/plan.

If we apply these guidelines to the Analysis, we see some obvious issues with the top 10 list. Actually, we will examine 13 funds, since we analyzed both class R-1 and R-6 shares for the three American funds that were in “Pensions & Investments” top ten list. Of the 13 funds, only four passed the AMVR screen. Seven of the funds failed to provide any positive incremental benefit/return (NA), and two of the funds had AMVR ratings greater than 1.0, indicating that the fund did produce a positive incremental return, but the fund’s incremental cost exceeded its incremental return.

The AMVR allows ERISA fiduciaries a relatively quick and simple means of beginning their required independent vetting of a plan’s investment options. Court decisions clearly establish that a fiduciary’s independent investigation of the merits of a particular investment a key element of the prudent person standard.

Some fiduciaries argue that they do not have a duty to evaluate potential investments for a 401k plan using a fund’s incremental cost and incremental return data, that simple annual return data and standard deviation data is sufficient. My response to that is two-fold. I would strongly suggest that fiduciaries review the recent decision in the Leber v. Citigroup action, where a court for the first time upheld the argument that in analyzing the prudence of a fund’s costs, Vanguard’s low cost funds are a viable benchmark.

Secondly, in evaluating the prudence of a fiduciary due diligence process, the courts do not limit their analysis solely to what the fiduciary actually knew.

[T]he determination of whether an investment was objectively imprudent is made on on the basis of what the [fiduciary] knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate. (emphasis added)(2)

A fiduciary obviously can tell if an actively managed mutual funds charges higher fees than a less expensive index fund with comparable, or even better, performance numbers. In that situation, I would submit that the question comes down to whether a fiduciary has a duty to determine whether the added incremental cost of the actively managed fund is justifiable based on a simple cost/benefit analysis  using a fund’s incremental cost and incremental return data, the same process used by the AMVR.

Based on my experience, the courts have looked favorably on the foregoing argument as by logical and persuasive. Other attorneys who have used the AMVR in their cases have reported  similar success. I believe that the simplicity of the AMVR and its ease of calculation has played a large part in its acceptance.

One question I often receive is why the AMVR does not factor in possible revenue sharing received by a 401(K) plan. Revenue sharing could be added into the calculation process. I choose not to include it in my work due to a number of factors. One of the primary reasons that I do not include revenue sharing in my reviews is due to the inability to independently verify the information and confirm how the money was actually used. There are too many reported instances of revenue sharing money being used inappropriately for me to ignore.

Another reason for my reluctance to include potential revenue sharing money in the AMVR process is the fact that the alleged purpose of revenue sharing is to help defray the plan’s administrative costs, not necessarily the plan participants’ investment costs, such as the annual fees and other costs associated with the plan’s investment options. The impact of said annual fees and other costs associated with the plan’s investment options are exactly what the AMVR evaluates.

A final reason for my decision not to include any revenue sharing in the AMVR calculation is the fact that revenue sharing will generally have little impact on a fund’s AMVR score. If a fund underperforms its benchmark, it will result in the fund providing no incremental benefit for the plan participant and obviously fail to meet the “best interests” requirement of any fiduciary standard.  Since most studies of the performance of actively managed mutual funds indicate that the majority of such funds underperform their appropriate benchmark, especially over the long term, potential revenue sharing money would have no impact on a fund’s eventual AMVR and fiduciary score

I believe that a major factor contributing to the ERISA fiduciary liability “gotcha” is the fact that far too often plan sponsors and other ERISA fiduciaries fail to do their own “careful and impartial independent investigation” as required by ERISA. Based on my experience, far too many ERISA fiduciaries blindly accept whatever their chosen service provider tells them or, if they do conduct their own independent investigation of a plan’s investment options, they fail to use prudent practices and/or fail to properly document their investigation and findings.

The danger in following this practice should be obvious given the obvious conflict of interests issue with someone who is both offering financial advice and selling financial products. As the courts have correctly pointed out,

One extremely important factor is whether the expert advisor truly offers independent and impartial advice. (3)

In many cases the service providers chosen by plan sponsors are affiliated with companies selling financial products, people such as stockbrokers or insurance salesmen. In rejecting such practices, the Bierwirth court issued a clear warnings to plan sponsors and other ERISA fiduciaries who decide to follow this practice. The Bierwirth court pointed out that a broker is not an impartial analyst, as his salary is either paid by the company he works for or his job is to close deals and generate commissions for himself and his company.

In relying upon the advice of another, [a fiduciary] should consider whether the person giving the advice is disinterested. Thus it is has been held that in purchasing securities for the defined contribution] plan, [a fiduciary] is not justified in relying solely on the advice of a broker interested in the sale of the securities. (Bierwirth, at 474)

Liability and Best Practices Implications for Plan Sponsors, ERISA Fiduciaries and Investment Advisers

The potential liability issues for plan sponsors and other ERISA fiduciaries are serious given the fact that the analysis found eight of the top ten mutual funds to present serious questions regarding their prudence under applicable fiduciary standard. As pointed out herein, the fact that a plan sponsor or other ERISA fiduciary meant no harm or was unaware of such questions of prudence will not protect the fiduciary if any of the plan’s investment options are determined to have been imprudent.

I have had plan sponsors, ERISA fiduciaries, and even some ERISA attorneys tell me that there is no real reason to worry about a plan’s investment options since the risk of plan participants losing money is relatively. Their attitude usually changes when I inform them that it is not necessary for a plan participant to lose money in order for a plan sponsor or other ERISA fiduciary to be found guilty of a breach of their fiduciary duties.(4)

Plan sponsors, ERISA fiduciaries and ERISA attorneys also like to try to defend themselves by saying that they are benchmarking their plan with other plans. Therefore, if their plan is doing it wrong, so are the other plans. If they are non-complaint, they are no worse than the other plans used in their benchmarking process.

My response is to tell them that their benchmarking process, if incorrect, simply means that they will all have to write checks if their plan is challenged by the DOL and/or their plan participants. Plan sponsors and ERISA fiduciaries need to understand that the DOL and the courts use an “absolute” scale to assess compliance, not a “relevant” scale.

Plan sponsors and other ERISA fiduciaries face a daunting task in selecting investment options for their plans. Fred Reish has acknowledged this challenge, offering his opinion that “many fiduciaries lack the expertise or access to the information needed to satisfy the prudent process requirement.”(5) In those situations, plan sponsors and other ERISA fiduciaries are urged to seek out professional advisers that can recommend prudent investment options. However, as mentioned earlier, a fiduciary’s reliance on third parties must be found to have been “reasonable” for a fiduciary to attempt liability for imprudent decisions.

No one knows for sure what changes will result in questions involving ERISA fiduciary liability once the DOL issues its new fiduciary standards. However, as both this white paper and the analysis point out, it is relatively easy and inexpensive for plan sponsors and other ERISA fiduciaries to conduct meaningful independent analyses of potential investment options using simple metrics such as the AMVR and a fund’s R-squared rating, and in so doing, protecting both plan participants, their beneficiaries and the plan’s fiduciaries.


(1) Fred Reish, “Participant Investing: Forewarned is Forearmed,” ERISA Report for Plan Sponsors,” September 2004, No. 7, No.2., available online at http://www.drinkerbiddle.com/resources/publications/2004/participant-investing-forewarned-is-forearmed?Section=FutureEvents ; Fred Reish, “Just out of Reish: A Good Defense,” PLANSPONSOR, September 2205, available online at http://www.plansponsor.com/MagazineArticle.aspx?Id=4294991584 
(2) Fink v. Nat’l Sav. and Trust Co., 772 F.2d 951, 962 (D.C.C. 1985); see also, Donovan v. Bierwirth, 538 F. Supp. 463 (E.D.N.Y. 1981); 29 C.F.R. § 2550.404a-1.
(3) Gregg v. Transportation Workers of America Internat’l, 343 F.3d 833, 841-842 (6th Cir. 2003).
(4) Spitzer v. Bank of New York, 43 A.D. 105, 349 N.Y.S. 2d 747 (1974); Leigh v. Engle, 727 F.2d 113 (7th 1983)
(5) Fred Reish, “Selecting and Monitoring 401(k) Plans,” available online at http://www.drinkerbiddle.com/resources/publications/2004/participant-investing-forewarned-is-forearmed?Section=FutureEvents.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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