May It Please the Court: Justice Denied As Courts Miss the Forest for the Trees in ERISA Actions

Price is what you pay, value is what you receive. – Warren Buffett

As any trial attorney will tell you, there are times when you wonder if a judge just does not understand a case or if you are just getting a good ‘ol serving of “home cookin’.” Reading some recent decisions in which a court has dismissed an ERISA action alleging excessive fees and/or a breach of one’s fiduciary’s duties, I can’t help but just shake my head, as the dismissals have supposedly been based at least in part on the business model of the plan’s respective mutual funds.

The courts in the cases have argued that using Vanguard mutual funds as benchmarks in ERISA cases is improper because Vanguard operates on a not-for-profit business model, while most actively managed mutual fund companies generally operate on a for-profit business model. Vanguard must be doing something right though, as they have more assets under management than any other mutual fund company, and growing every day. And therein lies the issue with the decisions to dismiss the ERISA actions based on a fund’s business model.

The purpose of ERISA is supposedly to help protect American workers’ retirement plan benefits and to help them work toward “retirement readiness.” As a result, it would seem that providing plan participants with effective investment options would be in the best interests of both plan participants and plan sponsors.

As the Supreme Court stated in their decision in Tibble v. Edison International,  the courts often look to the Restatement (Third) of Trusts (“Restatement”) for guidance on fiduciary matters, especially involving ERISA. Section 88 of the Restatement says that fiduciaries have a duty to be cost-conscious. Section 90, comment h(2) goes even further on a fiduciary’s duty to be cost-efficient, stating that due to the extra costs and risks typically associated with actively managed mutual funds, such funds should not be used for or recommended to clients unless their use/recommendation can be “justified by realistically evaluated return calculations” and can be “reasonably expected to compensate” for their additional costs and risks.

Simply put, the evidence overwhelmingly shows that the majority of domestic equity-based actively managed mutual funds cannot and do not meet the Restatement’s prudent investment requirements. Standard & Poor’s most recent SPIVA (Standard & Poor’s Indices Versus Active) report stated that approximately 90 percent of domestic equity-based funds failed to outperform their comparable benchmark over the past year.

In the most recent court decisions, the courts claimed that using Vanguard index funds for benchmarking would be like comparing “apples-to-oranges” due to the difference in the fund families’ business model. Nowhere in the decisions was there any mention as to the relative performance between the funds, the actual end-return benefit or value, if any, realized by the plan participants.

Since I enjoy doing forensic analyses of investments and pension plans, I figured I would perform such an analysis. Each year I perform a forensic analysis of the top ten mutual funds being used in defined contribution plans, as reported by “Pensions & Investments (“P&I”).” Past analyses are available online at the SlideShare site.

Using the top ten funds from P&I’s most recent report, I analyzed the five-year annualized returns (for the period ending on March 31, 2018) on the ten funds on both a nominal and risk-adjusted basis. I used four Vanguard index funds for benchmarking – VFIAX (large cap blend), VIGAX (large cap growth), VVIAX (large cap value), and VMMAX (midcap value). Total costs are based on a fund’s annual expense ratio and estimated trading costs, using John Bogle’s trading costs metric. My findings on the funds’ nominal and risk-adjusted incremental returns relative to each fund’s incremental total costs are as follows:

  • Fidelity Contrafund (FCNKX) – 91% of the fund’s fees/costs produced just 5.9% of the fund’s nominal return and 6.8% of the fund’s risk-adjusted return.
  • American Funds’ Growth Fund of America (RGAGX) – 82% of the fund’s fees/costs produced just 6.1% of the fund’s nominal return and 7.0% of the fund’s risk-adjusted return.
  • American Funds’ Washington Mutual (RWMGX)- 80% of the fund’s fees/costs produced just 4.2% of the fund’s nominal return and 5.1% of the fund’s risk-adjusted return.
  • American Funds’ Fundamental Investors (RFNGX)  – 87% of the fund’s fees/costs produced just 4.0% of the fund’s nominal return and 3.9% of the fund’s risk-adjusted return.
  • Dodge & Cox Stock (DODGX) – 88% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return and 6.9% of the fund’s risk-adjusted return.
  • Vanguard PRIMECAP (VMMAX)- 81% of the fund’s fees/costs produced just 15.2% of the fund’s nominal return and 16.8% of the fund’s risk-adjusted return.
  • Fidelity Growth Company (FGCKX) – 92% of the fund’s fees/costs produced just 25.0% of the fund’s nominal return and 25.0% of the fund’s risk-adjusted return.
  • T. Rowe Price Blue Chip Growth (RRBGX) – 95% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return. The fund failed to provide any positive incremental risk-adjusted return.
  • T. Rowe Price Blue Chip Growth (RRBGX) – 95% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return. The fund failed to provide any positive incremental risk-adjusted return.
  • MFS Value (MEIKX) – 88% of the fund’s fees/costs failed to provide any positive incremental nominal or risk-adjusted return.
  • Fidelity Low Price Stock (FLPKX) – 90% of the fund’s fee failed to provide any positive incremental nominal or risk-adjusted return.

With a few exceptions, those performances obviously do not come close to meeting the Restatement’s prudent investor standards. As is noted in the notes in Section 88 of the Restatement, “wasting beneficiaries money is never prudent.”

However, those statistics do not even tell the whole story. One of the most currently discussed investment issues internationally is the impact of “closet index” funds. Closet index funds are mutual funds that hold themselves out as providing active management and charge higher fees than index funds based on such claims. However, the truth is that such funds often closely track the performance of a comparable index fund or market index, often even underperforming the index fund. Higher fees for less return than a comparable index fund, essentially a net loss for an investor. Not sure how that situation furthers ERISA’s purposes.

I performed the same forensic analysis on the same ten funds using Ross Miller’s Active Expense Ratio (“AER”). The AER  calculates an actively managed fund’s effective annual expense ratio based on its R-squared number. R-squared is a metric that measures one fund’s correlation of returns with another fund or an actual market index.

In each case a fund’s incremental return numbers remained the same, but the percentage of the fee producing the returns all rose to 98% or 99%. The average AER number for the ten funds was 4.95 percent , about 9 times higher than the  funds’ stated average annual expense ratio of 0.549 percent. Again, not sure that the results of the actively managed funds’ closet index analysis are consistent with ERISA’s purposes or further the goal of “retirement readiness” for plan participants.

Keep in mind, these are the top ten funds currently used in defined contribution plans. The findings should be alarming enough. The fact that in some cases a fund’s entire incremental fee failed to produce any positive incremental return is a clear breach of the plan sponsor’s fiduciary duty. And yet the courts in question focused not on the miserable performance of such funds and the impact of same on plan participants’ retirement accounts, but rather on the available funds’ choice of business model.


Brokers and broker-dealers are celebrating the 5th Circuit’s adverse ruling against the DOL’s fiduciary rule, assuming that they cannot be held to a fiduciary standard in dealing with their ERISA customers.  I would suggest that such brokers and broker-dealers might want to review my previous post discussing how the regulatory and legal system have already been addressing the fiduciary issue. I would also suggest that broker-dealers and brokers review the applicable fiduciary state law in states that have adopted their own fiduciary standards or who are classified as quasi-fiduciary states, where state courts have the power to impose a fiduciary standard on brokers on a case-by-case basis, even in connection with non-discretionary accounts.

The DOL fiduciary rule may be dead and only time will tell whether the SEC adopts a meaningful universal fiduciary standard or merely a watered-down version of FINRA’s current suitability standard. Interestingly enough, FINRA came out in FINRA Regulatory Notice 12-25 and stated that their suitability standard and the “best interest” standard are “inextricably intertwined,” seemingly opening the door to a “fiduciary standard” interpretation, although FINRA did not expressly use the “f” word. Probably more double speak.

At the very least, the debate over the DOL rule has hopefully at least better educated investors with regard to the fiduciary conflicts-of-interest issue and raised their consciousness regarding the need to be more proactive in protecting their financial interests and security. Prudent investment advisers will embrace the new fiduciary movement and capitalize on the marketing opportunity it presents for them to demonstrate their value proposition to both existing and prospective clients. Lord knows, as my forensic analyses show, too many plan participants are currently receiving little or no value for their money.

 Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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.
This entry was posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, elder law, elderly investment fraud, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, investment advisers, investments, IRA, IRAs, pension plans, prudence, retirement plans, RIA, RIA Compliance, securities compliance, wealth management, wealth preservation and tagged , , , , , , , , , , , , , , , , , , , . Bookmark the permalink.