“Fundamental Unfairness: Defined Contribution Plans and the Courts-Part I”

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

Men occasionally stumble across the truth, pick themselves up and quickly
move on, as if nothing ever happened. – Sir Winston Churchill

I provide fiduciary oversight consulting services to pension plans and fellow attorneys. When a court issues a decision relating to ERISA and pension plans, I prepare an analysis of the decision and how it may affect their pension plan/litigation practice.

The courts have recently issued several decisions dismissing ERISA-based excessive fees/breach of fiduciary actions. The investment industry and plan advisers have gone online announcing that the tide has turned and such actions are a thing of the past.

To paraphrase Mark Twain, reports of the death of excessive fees/breach of fiduciary action have been greatly exaggerated. Once the courts consistently follow the applicable fiduciary standards set out in the Restatement (Third) of Trusts, I actually believe that the number of such cases will actually increase and result in more settlements or verdicts in favor in favor of plan participants. Plan sponsors should also adopt such standards into their practices to reduce their potential liability exposure.

When I take on a new consulting client, I explain my five “golden” rules, the five principles that I feel are essential to any ERISA risk management program:

  1. [ERISA] is intended to “promote the interests of employees and their beneficiaries in employee benefit plans.1
  2. The two primary duties of ERISA fiduciaries are the duty of loyalty and the duty of prudence.2
  3. The duties and responsibilities set out in ERISA are not exhaustive.3 In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts, as set out in the Restatement (Third) of Trusts (Restatement).4
  4. The use or recommendation of actively managed mutual funds is only prudent when the gains from such funds can be reasonably expected to compensate for its additional costs and risk, in other words, when the funds are cost-efficient.5
  5. Good faith does not provide a defense to a claim of a breach of one’s fiduciary duties; “a pure heart and an empty head are not enough.”6

The NYU Decision
Given my “golden” rules, the court’s recent dismissal of the excessive fees/breach of fiduciary duty action against NYU raises a number of questions. Even the court noted that it had some serious concerns given some of the facts of the case.

  1. “Fiduciary duties of loyalty and prudence” standard – Overall, the court did a good job in defining and applying the fiduciary duties of loyalty and prudence. As the court noted, the case was more about the fiduciary duty of prudence rather than the fiduciary duty of loyalty.

The court made one key misstatement of law that arguably influenced the court’s eventual decision.

Fiduciaries should consider the prudence of each investment as it relates to the portfolio as a whole, rather than in isolation.

With all due respect, while that is the standard for defined-benefit plans, it is not, and should not be, the applicable prudence standard for defined-contribution plans. This misstatement reflects a ongoing problem with the legal system not recognizing the difference between defined benefit and defined contribution plans.

The cases that the court cited in support of its mistaken “portfolio as a whole” position all involved defined-benefit plans, not defined-contribution plans. How much the court’s misstatement of the law  influenced the court’s overall analysis of the case may have to be decided by an appellate court.

In 2008, the Supreme Court finally acknowledged the crucial difference between defined benefit and defined contribution, recognizing that

[m]isconduct by the administrators of a defined benefit plan will not affect an individual’s entitlement to a defined benefit unless it creates or enhances the risk of default by the entire plan. For defined contribution plans, however, fiduciary misconduct need not threaten the solvency of the entire plan to reduce benefits below the amount that participants would otherwise receive. Whether a fiduciary breach diminishes plan assets payable to all participants and beneficiaries, or only to persons tied to particular individual accounts, it creates the kind of harms that concerned the draftsmen of §409.7

The Court then further supported its logic by pointing to ERISA section 404(c), which exempts fiduciaries from liability for losses caused by participants’ exercise of control over assets in their individual accounts. As the Court pointed out, this provision would serve no real purpose if fiduciaries never had any liability for losses in an individual account.

The significance of the difference between defined benefit and defined contribution plans in terms of plan participant risk was addressed by the court in DiFelice v. U.S. Airways.8 While the court upheld the lower court’s ruling in favor of the pension plan, the court explained the need to be careful in interpreting ERISA in cases involving defined contribution plans, especially the question of whether “investments in isolation” or “as part of the portfolio as a whole” is the applicable prudence standard.

Under ERISA, the prudence of investments or classes of investments offered by a plan must be judged individually.” That is, a fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to plan participants. Here the relevant “portfolio” that must be prudent is each available Fund considered on its own, including the Company Fund, not the full menu of Plan funds.

This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine with a company stock fund, could theoretically, in combination, create a prudent portfolio. To adopt the alternative view would mean that any single-stock fund, in which that stock existed in a state short of certain cancellation without compensation, would be prudent if offered alongside other, diversified Funds. Any participant-driven 401(k) plan structured to comport with section 404(c) of ERISA would be prudent, then, so long as a fiduciary could argue that a participant could, and should, have further diversified his risk. This result would be perverse in light of the Department of Labor’s direction that selection of prudent plan options falls within the fiduciary duties of a plan administrator.8

Footnote eight of the DiFelice decision should be memorized by every ERISA attorney and plan sponsor, as it perfectly summarizes the reason why defined benefit plans can evaluate potential investment in terms of the portfolio “as a whole,” but defined contribution plans cannot.

The court there determined that the defendant fiduciary could properly rely on modern portfolio theory because the fiduciary himself consciously coupled risky securities with safer ones to construct one ready-made portfolio for participants. (emphasis added)

 Here, in contrast, modern portfolio theory alone cannot protect U.S. Airways, which offered [an otherwise imprudent investment option] just because it also offered other investment choices that made a diversified portfolio theoretically possible.9

The key-“one ready-made portfolio” of a defined benefit plan” as opposed to “the numerous, participant-selected accounts dependent on the investments chosen by a plan” of defined-contribution plans. There are some who will argue that footnotes do not carry the same weight as a court’s actual decision. I would argue that an attorney can absolutely take the logic set out in the footnote and successfully adopt and argue the same, especially when it is supported by common sense.

Bottom line, it would clearly be inequitable to include imprudent investment options in the limited investment options offered to defined contribution plan participants, especially when ERISA does not require that plan participants be provided with meaningful education programs that allow them to detect such imprudent investments.

The question in the NYU case is to what extent did the court’s “portfolio as a whole” position impact the court’s ultimate decision. That may be up to an appellate court to determine.

3 & 4. – ERISA not exhaustive” and “cost-efficient actively managed funds” standards
It should be noted that the court did reference the Restatement and the Prudent Investor Rule (Rule) in discussing the fact that actively managed mutual funds are acceptable investments in pension plans. However, for some reason the court failed to mention the fact that both the Restatement and the Rule clearly condition the prudent use of actively managed funds in pension plans on such funds being cost-efficient.

Restatement Section 90, comment b, states that fiduciaries have a duty to be cost conscious. Building on that duty, Section 90, comment h(2) states that

Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs, … These considerations are relevant to the trustee initially in deciding whether, to what extent, and in what manner to undertake an active investment strategy and then in the process of implementing any such decisions….Accordingly, a decision to proceed with such a program involves judgments by the trustee that gains from the course of action in question can be reasonably be expected to compensate for its additional costs and risk10

 Translated, only cost-efficient actively managed funds are appropriate for fiduciaries. Just common sense. Funds that are not cost-efficient result in net losses for an investor. As the commentary to Section 7 of the Uniform Prudent Investor Act points out, “wasting beneficiaries’ money is imprudent.”11

In reviewing recent court decisions dismissing ERISA-based actions alleging excessive fees and/or breach of fiduciary duties, there is a definite, and troubling, trend of courts arguing that there are certain ranges of annual fees which are acceptable as a matter of law. The NYU court even stated that the fees in that case were within the range of acceptable fees and that such fees were acceptable as a matter of law.

First, neither ERISA nor the Restatement (Third) of Trusts state that there is an acceptable range of annual fees for any type of mutual funds.  Second, the suggestion that there are legally acceptable ranges of random annual expense ratios based solely on a fund’s stated annual expense ratio is totally inconsistent with the standards established by the Restatement, more specifically Section 90, commonly known as the Prudent Investor Rule (Rule)

It is improper for a court to grant a motion to dismiss if there are legitimate questions of fact unresolved. In a number of the recent dismissals, the courts have claimed that courts approval of certain ranges of annual expense ratios constitute matters of law. Again, the argument that fees are prudent, without any consideration of whether the funds provide a commensurate level of return for such fees, is highly questionable, a fact the Restatement readily acknowledges.

Given the authority for requiring fiduciaries to evaluate actively managed funds in terms of their cost-efficiency, the plaintiffs’ bar should consider framing future excessive fees/breach of fiduciary duty actions in terms of the cost-efficiency standard. Such a strategy should prevent dismissals since cost-efficiency is clearly fact-specific and thus a matter of fact, not a question of law.

Proactive plan sponsors should definitely adopt such an approach in conducting their legally required independent investigation and evaluation and obtain such information, in writing, from all plan advisers. The cost-efficiency standard also (1) quantifies the prudence of an investment, (2) avoids the whole absurd argument over Vanguard funds as benchmarks, (3) removes the subjectivity often associated in fiduciary arguments, and (4) allows for prudence analyses of “unique” funds such as those at issue in the NYU case, avoiding the issue of questionable benchmarks or no benchmark at all.

5. “Pure heart and empty head” and “promote the interests of plan participants” standard
ERISA’s stated purpose is intended to promote the interests of employees and their beneficiaries in employee benefit plans. In order to do that, pension plans and their investment committees must actually be competent to provide the plan’s required service and care enough to do so properly.

In discussing the composition of the NYU investment committee, the judge noted that some of the members admitted to generally lacking the knowledge and experience to effectively serve on the committee. Some admitted to blindly accepting whatever the plans’ adviser told them, which the court noted is a violation of the law. The court also noted that one committee member was unsure if he was even a member of the committee, while another committee member indicated that she had little time for, interest in, or desire to be on the committee. The committee’s decisions clearly reflect both their overall lack of interest in their fiduciary duties and their breach of their breach of their fiduciary duties.

And yet, for some reason, at first impression, it appears the court ignored these serious “red flags.”

If the NYU court’s decision is appealed, I would anticipate the appeal to focus on

  • the court’s failure to apply the Restatement’s cost-efficiency standard for the actively managed funds in the university’s plans;
  • the appropriateness of the standards that the court did apply, e.g., absolute ranges of expense ratios as a “matter of law;”
  • the court’s application of a “portfolio as a whole” standard to the two defined contribution plan;
  • the court’s willingness to dismiss questions as to the overall composition of the plans’ investment committees and the question of whether the committees fulfilled their fiduciary duty to conduct meaningful investigations and evaluations of the plans’ investments.

Going Forward
I have received a lot of calls from both plan fiduciaries and attorneys asking me what they should do given these dismissals. Just my opinion, but I think we might see the plaintiffs’ bar starting to plead these cases relying more on the Restatement’s cost-efficiency standard in connection with the use actively managed mutual funds in pension plans..

First, it is an objective standard from a resource that the courts acknowledge and respect. Second, it will put an end to the “acceptable range of annual expense ratios” argument that plans have been arguing and, unbelievably, some courts have adopted, even though the argument is totally inconsistent with the Restatement, the legal concept of unjust enrichment, and simple common sense.  The idea that random numbers representing a range of annual expense ratios, without consideration of whether a fund provided a return commensurate level of return for such costs, simply makes no sense, a point the Restatement thankfully recognizes.

Finally, by pleading the Restatement’s cost-efficiency requirement for actively managed mutual funds, the plaintiffs’ bar should be able to effectively prevent wrongful dismissals by focusing the courts on the facts of the case, “facts” being the key word. Assuming that an action is properly plead and within the applicable statute of limitations, cost-efficiency questions are clearly dependent on the specific facts of the case, the relationship between a fund’s costs and its returns. It is improper for a court to dismiss an action when there are legitimate unresolved questions of fact.

My advice to plan fiduciaries is to be proactive and adopt the Restatement’s cost-efficient standard in performing their legally required independent investigation and evaluation of their plan’s investment options. Most plan advisers are not going to provide such information, especially since a well-known study found that most actively managed mutual funds are not cost-efficient.14 I cannot remember ever seeing a advertisement for an actively mutual fund ever touting the fund’s cost-efficiency.

Plan fiduciaries can use my free metric, the Active Management Value Ratio™ 3.0 (AMVR), to quickly and easily calculate the cost-efficiency of the funds they are considering for their plan. For information about the AMVR and a simple worksheet to perform the required calculations, click here and here.

As an attorney, the NYU decision is troublesome not only because of the issues I have discussed, but also because, in my opinion, it is a perfect example of the legal system’s continuing failure to recognize and respect the fundamental differences between defined benefit and defined contribution plans. Having read all of the recent decisions dismissing ERISA-based excessive fees/breach of fiduciary duty actions, not one of the decisions mentioned the Restatement’s “cost-efficiency” standard for actively managed funds.

Just like the NYU court, recent dismissal decisions have focused primarily on the returns of a plan’s funds and the idea of a “legally acceptable” range of annual expense ratios, a premise that is totally inconsistent with the Restatement’s “cost-efficient” requirement for actively managed funds.

In closing, I would strongly recommend that judges, plan sponsors and anyone involved in the defined contribution arena read the DiFelice v. U.S. Airways decision, especially footnote eight. The decision actually ruled in favor of the pension plan. However, the court took the time to address the fundamental differences and the resulting adjustments courts and ERISA fiduciaries must make to ensure that defined contribution plan participants and their beneficiaries receive the protection that ERISA was created to provide and that allows them the opportunity to become “retirement ready.”


  1. Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 90 103 S.Ct 2890.
  2. DiFelice v. U.S. Airways, 497 F.3d 410, 417, 418 fn. 8; Moench v. Robertson, 62 F.3d 553, 561 (3d Cir. 1995).
  3. Central States, Southeast & Southwest Areas Pension Fund v. Central Transport, Inc., 472 U.S. 559, 570.
  4. Tibble v. Edison Internat’l, 135 S. Ct. 1823, 1828 (2015)
  5. Restatement (Third) of Trusts, 90, cmt h(2).
  6. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th 1983).
  7. LaRue v. DeWolff, Boberg & Associates, Inc., 552 U.S. 248 (2008).
  8. DiFelice, 423-424; Langbecker v. Electronic Data Systems Corp., 476 F.3d, 303, 308 n.18; see also In re Unisys Sav. Plan Litig., 74 F.3d 420, 438-41 (3d Cir. 1996).
  9. DiFelice, 423-424.
  10. Restatement (Third) of Trusts, Section 90, cmt h(2).
  11. Uniform Prudent Investor Act, preamble to Section 7.
  12. Shaw, supra.
  13. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.

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™ 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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