“Best Interest,” BICE and Liability Exposure for Plan Sponsors

I recently posted an article in various LinkedIn groups that addressed the need for various parties to address their duties and potential liability under the DOL’s new fiduciary standard. My comment that accompanied the post was

Based on my personal experience and feedback thus far, very of few of those mentioned in the article truly understand both the “best interests” standard and BICE.

My point is simply this – based on my experience in conducting forensic fiduciary prudence audits and analyses, I believe that most plan sponsors and other plan fiduciaries lack the knowledge and experience to properly evaluate the prudence of mutual funds and/or variable annuity subaccounts (403(b) plans).

This point was addressed in detail in  “The Adequacy of Investment Choices Offered by 401(k) Plans,” an article by three finance professors, Edwin. J Elton, Martin J. Gruber, and Christopher R. Blake. The professors reported that for 62 percent of the 400+ 401(k) plans studied, the types of choices offered were inadequate, with difference in fund expenses playing a pivotal role in reduced performance. The study ultimately found that

If investors are given an inferior set of choices in their plan, the effectiveness of their choice is seriously constrained….

Over a 20-year period, ( a reasonable investment horizon for a plan participant), the cost of not offering sufficient choices makes a difference in terminal wealth of over 300%. Since, for more than one half of plan participants, a 401(k) plan represents the participant’s sole financial asset, the consequences are serious.

The study’s findings regarding the negative impact of a fund’s fees and expenses on a fund’s end return is not only common sense, but has been supported by other studies. Burton Malkiel has found that the two best indicators of a fund’s future performance are the fund’s expense ratio and its trading costs.

The primary investment options in many 401(k), 403(b), 457(b) plans and variable annuities are actively managed mutual funds, this despite studies, such as Standard & Poor’s annual SPIVA reports, that have consistently shown that historically most actively managed mutual funds have underperformed passively managed funds, commonly referred to as “index” funds. And yet, plan sponsors continue to load their plans with the underperforming, excessively priced actively managed mutual funds, and then express surprise when they get sued for such fiduciary breaches and eventually settle the case for millions of dollars.

Sponsors were sent a clear message regarding their fiduciary duty to control the investment costs of their plan when the federal district court for the Southern District of New York, the court for the Wall Street district, denied a plan’s motion to dismiss a case filed by the plan’s participants alleging that the plan chose mutual funds charging the participants excessive fees. In denying the motion to dismiss, the court noted that

Essential to the plausibility of plaintiffs’ claims was the allegation that the Affiliated Funds ‘charged higher fees than those charged by comparable Vanguard funds—in some instances fees that were more than 200 percent higher than those comparable funds.’

The court’s explicit acceptance of Vanguard’s funds as appropriate benchmarks in assessing the prudence of the fees has been duly noted by the plaintiff’s bar, and should be likewise noted by plan sponsors and other investment fiduciaries. While the court’s decision is technically only binding on that court, the fact that the court routinely handles cases involving Wall Street and securities issues, as well as the pure common sense rationale behind the decision, ensures that it will be cited in cases involving excessive fees and fiduciary duties issues. And yet, I have found that plan sponsors, and even some ERISA attorneys, are totally unaware of the court’s ruling. For those who want to review the court’s decision, the case is Citigroup v. Leber.

Simply put, there are going to very few instances where a plan’s actively managed investment options are going to be less expensive than a comparable Vanguard fund, especially when the actively managed fund’s expense ratio and its trading costs are considered. In most cases, the actively managed fund’s combined expense ratio/trading costs expenses will often be three times as expensive as those of the comparable Vanguard fund. Given these facts, it is easy to see why the expectation is that cases alleging a plan sponsor’s breach of their fiduciary duties will continue to be filed and settled for millions of dollars. This is also why there is an expectation that 403(b) and 457(b) plans may soon face similar breach of fiduciary duty claims.

Quantifying Fiduciary Prudence With the Active Management Value Ratio™ 2.0

I developed a metric, the Active Management Value Ratio™ (AMVR), to allow investors, plan sponsors and other investment fiduciaries to properly evaluate the prudence of investments, especially actively managed mutual funds and variable annuity subaccounts. An explanation of the principles behind the AMVR, as well as the calculation process, is available here.

The AMVR is based on the studies of investment icons, Charles D. Ellis and Burton Malkiel. Malkiel’s findings re the importance of a fund’s fees and trading costs have already been noted. Ellis noted that index funds have essentially become like commodities, where an investor knows that they will essentially receive the return of the market at the market’s risk level. As a result, Ellis suggested that in evaluating actively managed mutual funds,

[r]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.

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 the incremental fees for active management are really, really – on an average, over 100% of incremental returns.

That’s right: All the value added-plus some- goes to the manager, and there’s nothing left over for the investors who put up the money and took the risk.

And there’s the foundation for a closing argument against a plan sponsor on a claim of breach of the fiduciary duties of loyalty and prudence. Throw in the simple addition, subtraction and division required to calculate the AMVR to provide the evidence of imprudence and all that’s left to do is enjoy the proverbial “checkmate” over the plan and it’s fiduciaries. A plan sponsor’s pleas of not meaning any harm and/or lack of knowledge of such facts are irrelevant on the issue of fiduciary liability, as the courts have consistently ruled that “a pure heart and an empty head are no defense to breach of fiduciary claims.”

In both my law and fiduciary consulting practices, my friends and foes have come to refer to my use of the AMVR as “running the AMVR gauntlet” since I have developed a systematic procedure for effectively using the AMVR. The “gauntlet” involves the following steps/questions:

(1) Does the actively managed mutual fund produce a positive incremental return, i.e., alpha, for an investor? If not, the fund results in a loss for an investor and is therefore not a prudent investment.

(2) If the actively managed fund does produce a positive incremental return, is the fund’s incremental return  greater than the fund’s incremental cost in producing said incremental return? If not, the fund results in an overall loss for an investor and  is therefore not a prudent investment.

(3) If the actively managed mutual fund provides an incremental return that exceeds the fund’s incremental costs, does the fund’s R-squared rating qualify the fund as a “closet index” fund? By definition, closet index funds, aka “index huggers,” are funds that closely track their underlying market index, meaning most of their returns can be attributed to the performance of the market index rather than the active management of the fund. In my practice, I classify any actively managed mutual funds with an R-squared rating of 90 and above as a closet index fund.

The fiduciary liability aspect of closet index funds comes from the fact that they not provide the same, in some cases less, returns than an index fund at a fee that is often two or three times higher than the index fund’s fee. Therefore, closet index funds are not a prudent investment.

(4) To further evaluate a closet index fund, I use a proprietary metric, the Active Management Fee Factor™ (AMFF), to factor in a fund’s R-squared rating to calculate the effective fee for a fund. In cases where a fund has a high R-squared rating of 90 or above, the effective expense ratio is often 6-7 times higher than the fund’s stated expense ratio. I then re-calculate the fund’s AMVR score using the fund’s AMFF score. In most cases, the R-squared adjusted AMVR is well above 1.0, meaning the fund’s effective incremental costs far exceed the fund’s incremental return, thereby making the fund imprudent.

I advise my fiduciary consulting clients to use the same system. I know attorneys that use “the gauntlet” in their securities and ERISA practices. While relatively simple, going through the steps and getting a plan sponsor or other investment fiduciary to admit the imprudence of a fund after each step makes for an impressive and informative presentation.

“All Hands On Deck”

The article I posted on LinkedIn basically warned that all parties in the ERISA arena need to learn how the DOL’ new fiduciary rule, including the BIC exemption, does or could impact their services and legal duties. My experience has been that most plan sponsors blindly rely on whatever their service providers tell them. This is dangerous for several reasons.

In most cases, plan sponsors mistakenly believe that they have recourse against their service providers if the information provided to the plan sponsor is incorrect. In truth, most service providers use contracts that effectively limit any fiduciary liability for the information they may provide to a plan. Plan sponsors should always have service provider contracts reviewed by experienced counsel in order to determine the existence of any exculpatory provisions.

Secondly, the courts have consistently ruled that any reliance by plan sponsors on information provided to them by third-parties must be justifiable in order to provide any defense to potential liability. Plan sponsors should be aware that the courts have held that reliance on stockbroker, insurance agents and others with a potential financial interest in the advice they provide is never justified.

Plan sponsors and others need to be able to independently evaluate the potential investment options for their plans, both as part of the initial selection and as part of their ongoing fiduciary duty to monitor the plan’s investment options. Evaluating funds based solely on annual returns and standard deviation of returns data is not acceptable, as it ignores other important factors in the fiduciary prudence equation. While the AMVR is obviously not the only means for a plan sponsor or other investment fiduciary to meet their fiduciary duties of loyalty and prudence, it does provide a simple, yet effective, means of doing so.


Under the DOL’s new fiduciary rule, an understanding of the meaning of ‘best interest” will be crucial in avoiding unwanted fiduciary liability exposure, both in terms of the rule’s general fiduciary obligations and the Best Interest Contract (BIC) exemption.  Financial advisers and investment fiduciaries often claim that they do not  understand the meaning of the fiduciary “best interest” duty. While such claims often ring hollow, under the DOL’s new fiduciary rule, plan sponsors and other investment fiduciaries need to be able to document that they used a legally appropriate due diligence process in evaluating and selecting investment options for their plans if they have any hopes of avoiding liability for breach of fiduciary liability claims since, as mentioned earlier, the courts will not accept ” a pure heart and an empty head” defense.

 © Copyright 2016 The Watkins Law Firm. All rights reserved. 

This article is for informational purposes only, and is not designed or 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.

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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