What Mr. Schlichter Understands…and Plan Sponsors and Investment Fiduciaries Need to Understand As Well

This week attorney Jerome Schlichter, already known for his actions against 401(k)s and plan sponsors for alleged breaches of their fiduciary duties, added a new category of defendants to his practice, 403(b) plans of private colleges and universities. By my count, he has filed twelve such actions to date against some of the most well-known colleges and universities in America.

Mr. Schlichter’s new strategy apparently surprised a lot of people, as they thought colleges and universities were not covered by ERISA and therefore were protected against such actions. While state colleges and universities are generally not subject to ERISA’s requirements, private colleges and universities are not afforded such protection. For future reference, it should be noted that even the 403(b) plans of state colleges and universities are subject to similar breach of fiduciary charges under a state’s common laws, such as agency, negligence and breach of contract laws. Click here for more information about possible fiduciary liability of non-ERISA pension plans.

The new complaints filed by Mr. Schlichter this week against the college and university 403(b) plans included many of the same allegations contained in his 401(k) actions – excessive fees and imprudent investment options within the plan. One of the more interesting new allegations in the 403(b) complaints was an allegation that the plans contained too many investment options, in some cases hundreds of investment options, many of which were similar to or duplicative of each other, arguably reducing the plan’s ability to negotiate with the plan’s service providers for more favorable concessions for the plan’s participants.

Having personally conducted forensic analyses on a number of 403(b) and 457(b) plans of American colleges and universities, these new actions should not have come as a surprise to anyone. One noticeable trait of the 403(b) and 457(b) plans of American college and universities is the fact that most of them have the same three service providers (TIAA-CREF, VALIC, and Fidelity Investments) and, in  most cases, offer exactly the same or extremely similar menu of investment options within their plan. For reason, I believe that more such actions will be filed by Mr. Schlichter and other firms, as the similarity between the 403(b) plans may well foretell a domino effect in both the filing of complaints and settlements of such actions.

The claims with regard to the alleged excessiveness of the plans’ fees should be easy to prove. As Mr. Schlichter, the fact that many of these plans were paying various fees to the three previously mentioned service providers, instead of trying to minimize costs by reducing the number of service providers, should be an easy argument to win.

The allegation regarding the imprudence of a plan’s investment options is something that, to be honest, continues to amaze me due to the fact that plan sponsors and other investment fiduciaries still either have not figured out their fiduciary duties in this area or simply have not figured out how to properly conduct a fiduciary prudence analysis.

As a fiduciary attorney and compliance officer/consultant, who has dealt with the fiduciary issues for some time, I decided to create a metric that investors, attorneys, plan sponsors and other investment fiduciaries could use to quickly and effectively evaluate the prudence of actively managed mutual funds. For those fearful of some complex mathematical function, math was never one of my favorite subjects in school. In fact I talked my way out of calculus in both high school and college since I was going to be an attorney. The metric, the Active Management Value Ratio™ 2.0 (AMVR) only requires the ability to add, subtract multiply and divide. Click here for more information about the AMVR and the required calculation process.

A fiduciary’s duty to conduct an independent and thorough investigation and analysis of any and all investments recommended and chosen for an account or a plan is essentially black letter law. A failure to satisfy this requirement is a clear breach of a fiduciary’s duty of prudence. In my securities practice, investment advisers and other investment fiduciaries know that they are definitely going to get asked three questions regarding the process they used to determine the prudence of the investments that they recommended to a client or a plan.

The first question to do with a fund’s nominal, or stated, annualized return. While there is no required time period for evaluating a fund’s annualized returns, the prudent fiduciary will normally choose a period of five or more years so that at least one down period is included to get a better idea of how the fund performed in both up and down markets. Unfortunately, too many investment fiduciaries look at a fund’s nominal returns and the fund’s standard deviation and believe that they have met their fiduciary duties. Obviously, I do not subscribe to that school of thought since I still have two more questions.

My second question has to do with whether the fiduciary evaluated a fund in terms of its risk-adjusted return. Many investment professionals dismiss risk-adjusted returns with the statement that “investors can’t eat risk adjusted returns.” My response is always that a failure to factor in a fund’s risk-adjusted returns may mean that eventually they cannot eat at all. In some cases, a fund’s risk-adjusted returns may actually make an otherwise imprudent fund, based on its nominal returns, into a prudent investment choice. What too many fiduciaries fail to consider is that a fund’s nominal return may not reflect the fact that a fund achieved a respectable return while assuming far less risk than a fund with slightly higher nominal returns.

My third question always addresses any possible “closet index fund” issues. Given the trend over the past decade of equity-based mutual funds, both domestic and international funds, to display a higher correlation of returns, the “closet index fund” issue has become an important in regard to fiduciary prudence, at least in the context of fiduciary litigation. The fiduciary’s duty to control investment costs and avoid wasting money is another basic and incontestable fiduciary duty.

When questioned about the “closet index fund”  issue and whether they considered this issue in their investigation and analysis, most fiduciaries will admit that they did not do so and that they had no idea how to even do so. Unfortunately, ignorance is no excuse. Even though investment fiduciaries are required to conduct their own independent investigation of potential investment options, the law allows, even encourages, fiduciaries to retina the services of experts if necessary to ensure that they fulfill their fiduciary duties of loyalty and prudence, their duty to put their clients or the plan participants’ best interests first.

In evaluating the potential impact of the “closet index fund” issue, there is no universally required metric or threshold. For that reason, most attorneys and fiduciaries rely on a metric known as the Active Expense Ratio (AER), a metric created by Professor Ross Miller. The AER converts a fund’s R-squared ratio into a number that arguably reflects the effective annual expense fee being charged by a mutual fund. Miller’s study found that in most cases, the AER for a fund is often much higher than the fund’s stated expense ratio, in some cases 6-8 times higher. In my practice, I use a metric I call the Active Management Fee Factor (AMFF), that is modeled after the AER, with some minor modifications to factor in elements that I think are important.

In my presentations in these subjects and the AMVR, I have found that an example helps people understand these principles. Fidelity offers a number the K share version of its more popular mutual funds in 401(k) and 403(b) plans. One of the more well-known Fidelity funds is the Contrafund. Will Dannoff, the long-time manager of the fund, is well-respected and often mentioned in the ranks of the legendary mutual fund managers. In the past, I have often recommend the fund to people who ask me for a recommendation.

But Contrafund is an excellent example of the value of conducting a thorough and objective fiduciary investigation and evaluation of a mutual fund. Based on Contrafund’s most current summary prospectus (available at morningstar.com, under the “Filings” tab on the Contrafund page), the fund has an annual expense ratio of 70 basis points (o.70), an annual turnover ratio of 35 percent, and an five-year annualized return of 12.80 percent. (Unless otherwise indicated, the figures referenced herein reflect the period ending December 31, 2015). Using the AMVR, we calculate the fund total costs for purposes of comparison as 112 basis points (1.12%).

For any comparison to have merit, it is important to ensure that the study compare similar funds, to compare “apples to apples.” While many choose to use Vanguard’s S&P 500 Index Fund (VFINX) as the benchmark for comparisons for any equity-based mutual fund, I do not believe that is a valid approach unless the fund being studied is also classified as a large cap blend fund, since that is how both the S&P 500 and VFINX are classified. Contrafund is categorized as a large cap growth fund.

I order to ensure an “apples to apples” comparison, I will use Vanguard’s well-known Growth Index fund (VIGRX), which is also classified as a large cap growth fund by Morningstar, as my benchmark. Morningstar  states that the Growth Index fund has an annual expense ratio of 22 basis points (o.22), an annual turnover ratio of 9 percent, and an five-year annualized return of 12.96 percent.

Using the AMVR once again, we calculate the fund total costs for purposes of comparison as 32 basis points (0.32%), resulting in Contrafund having 80 basis points in incremental, or additional, fees/costs (112bp-32bp). Contrafund’s annualized returns are less that the Growth Index fund’s annualized returns, so Contafund fails to provide a positive incremental return. Combining the incremental data, the Contrafund is clearly a less cost-effective choice than the Growth Index fund. Given the closeness of the annualized returns, one might still make an argument for Contrafund. But when one considers that each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17 percent over twenty years, Contrafund’s 80 bp in incremental makes that argument hard to accept from a fiduciary standpoint.

The next step is to evaluate both funds from a risk-adjusted standpoint. To calculate each fund’s five-year annualized risk-adjusted returns we will simply use their respective five-year standard deviation numbers. Contrafund’s five-year risk adjusted return was actually higher than the same return for the Growth Index fund, resulting in a positive incremental return of 58 basis points (0.58%). However, the fund’s incremental risk-adjusted return is less than the fund’s incremental costs (80 bp), so the fund would be considered as imprudent by most people still it would still result in an overall loss for an investor, albeit small . In cases like this, a fiduciary might want to do additional investigation and analysis using rolling five-year periods to determine if the most recent five-year period reflects the fund’s overall performance history or not.

At this point I am sure that some readers are thinking that my methodology is solely for the purposes of advocating that only no-load/index funds are acceptable investment options with investment portfolios and pension plans. That simply is not true.

Each year I do an analysis of the top 10 mutual funds used in defined contribution plans, as reported by “Pensions and Investments” magazine. Fidelity Contrafund is a regular on the list. In my most recent analysis, four actively managed passed the prudence test by providing positive incremental returns in excess of their incremental costs – Vanguard PRIMECAP Admiral, T. Rowe Price Growth Stock, T. Rowe Price Blue Chip Growth, and American Funds Washington Mutual R-6 share class. However, all four of the funds had a R-squared score above 90, and thus would be classified as “closet index” funds, and thus imprudent, under my system. The fact that four actively managed funds passed the incremental return/incremental costs screens show that my system, which demanding, can be met by some actively managed funds.

In the final analysis, we will use the funds’ respective R-squared scores to compare their respective effective annual expense ratios. Morningstar shows Contrafund having an R-squared score of 86.35, which equates to an AER of 2.42. The Growth Index fund’s R-squared score is 94.27, which equates to an AER of 1.11. The significant difference between the AER scores once again suggests that the Growth Index fund is a more cost-effective, and thus a more prudent, investment choice.

In using a fund’s R-squared score, fund with a high R-squared score and/or a incremental cost number will have a high AER score. Some attorneys and fiduciaries do not compute a fund’s AER score at all, preferring to set their own threshold R-squared score for classifying a fund as a “closet index fund,” and thus eliminating the fund from consideration. As mentioned earlier, there is no universally designated “closet index” R-squared score. I know some people that use a score of 95 as their threshold and others that use a score as low as 80 as their threshold. I personally use a R-squared score of 90 in my analyses.


While various factions debate the proper way to define and evaluate fiduciary duty, prudence and “best interests,” TIAA-CREF succinctly addressed all three in a white paper, stating that

Plan sponsors are required to look beyond the fees and determine whether the plan is receiving value for the fees paid.

Short, simple and accurate. While the article is written in terms of 403(b) plans, the logic expressed is obviously equally applicable to 401(k) plans and wealth management in general.

The Active Management Value Ratio provides investors, attorneys, plan sponsors and other investment fiduciaries with a simple, yet effective, means of determining whether an investor or a plan is in fact receiving value for the fees and other costs it is paying a fund. If a fund is not producing a positive incremental return, or if the fund’s incremental is less than the fund’s incremental costs, then a fund is not providing any value for the fees and costs paid. It’s just that simple

Investment fiduciaries should always remember that fiduciary liability results not from the actual performance of the investments chosen, but rather on the failure to use a prudent process in selecting said investments. Given the soundness and thoroughness to the methodology discussed herein, I believe that this approach to fiduciary prudence analysis can provided plan sponsors and other investment fiduciaries with an effective means of fulfilling their fiduciary duties.

© Copyright 2016 InvestSense, LLC. 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™ member 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 on sound, proven investment strategies that will help them protect their financial security.
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