As I mentioned in an earlier post, a number of recent decisions dismissing 401(k)/403(b) excessive fees/breach of fiduciary duties actions have highlighted the issue of fundamental fairness in the courts involving ERISA issues. The recent dismissal of the Checksmart action is a perfect example of the judicial/ERISA issues.1
The plaintiff made the typical allegations of excessive fees and breach of the fiduciary duty of prudence. The court dismissed the plaintiff’s action, applying the three-year statute of limitations based on the court’s interpretation of ERISA’s “actual knowledge” of the plan sponsor’s alleged breaches.
The court stated its position that
‘actual knowledge’ really means ‘knowledge of the underlying conduct giving rise to the alleged violation’ rather than ‘knowledge that the underlying conduct violates ERISA.’2
The court then held that the three-year statute of limitations began to run when the plan advised plan participants of the funds’ expense ratios.
There are presently three different interpretations of the “actual knowledge” standard within the federal court system. The actual text of the three-year statute of limitations states as follows:
No action may be commenced under this subchapter with respect to a fiduciary’s breach of any responsibility, duty, or obligation under this part, or with respect to a violation of this part, after the earlier of—
(2) three years after the earliest date on which the plaintiff had actual knowledge of the breach or violation;…3
On its face, taking the words at their common meaning, the three-year statute of limitations would seem to require actual knowledge of the breach or violation. As I discussed in my last post, the law is well-settled that a fiduciary relationship
creates [a] climate of trust in which facts that would ordinarily require investigation may not excite suspicion, and the same degree of diligence is not required.4
As respected ERISA attorney Fred Reish pointed out in his testimony before the DOL, most plan participants lack the knowledge of and experience with basic investment fundamentals to effectively manage their retirement accounts. And yet, the Checkmart court placed that burden on plan participants.
The clear inequity of such a position was recognized in the Hecker II court’s decision, as the court stated that the sheer number of investment options in a plan does not insulate a plan sponsor from potential liability for a breach of their fiduciary duties. As the court pointed out,
it could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives.5
As noted, there are currently three different interpretations of ERISA’s “actual knowledge” statute of limitations standard. Some of the courts, like the Checksmart court, only require that a plan participant have knowledge of the underlying the transaction creating the violation, but not that a violation has occurred. Other courts require that a plan participant have actual knowledge of the transaction and the fact that it constitutes a violation of ERISA. A third group of courts have adopted a hybrid interpretation of the “actual knowledge” requirement. For an excellent analysis of the “actual knowledge” issue, click here.
Regardless of one’s position on the “actual knowledge” requirement, the fact remains that it results in an inequitable situation where a plan participant’s ERISA protections may depend on where they live rather than the facts of their case. This a clearly inconsistent with the stated purpose of ERISA – to promote the interests of employees and their beneficiaries in employee benefit plans.
When there are such inconsistencies between the federal appellate courts involving significant laws, the Supreme Court will usually agree to hear the case and settle the issues to ensure uniformity in interpretation and applicability of the law. Hopefully, the plaintiffs in the Checksmart action will pursue that course of action to resolve this ongoing problem.
Other Unresolved Interpretation Issues
In order to ensure that ERISA is interpreted and applied consistently and equitably across all legal venues, there are other issues that need to be addressed.
The “Vanguard Funds Are Unacceptable Benchmarks” Defense
The recent Putnam 401(k) excessive fees/breach of fiduciary duties action involved the three-year statute of limitations.6 The case also involved the issue of whether Vanguard mutual funds are acceptable benchmarks for deciding breach of fiduciary duty issues. The court rejected the Plaintiff’s expert’s testimony based primarily on the difference between Vanguard’s business model and the business model of most actively managed funds, with the court stating that
[the expert’s] comparison, however, is flawed. Vanguard is a low-cost mutual fund provider operating index funds “at-cost.” Putnam mutual funds operate for profit and include both index and actively managed investment. [The expert’s] analysis thus compares apples and oranges. Moreover, even if the Court were to accept the Plaintiffs’ account of the range of Putnam mutual fund expense ratios or average management fees, the Plaintiffs cite no relevant case law holding that such ranges or averages are unreasonable as matter of law.7
With all due respect, I would argue that these two arguments illustrate what is flawed in the current thinking in 401(k)/403(b) fiduciary breach of duty actions. If we accept the Supreme Court’s position that the purpose of ERISA is to promote the interests of employees and their beneficiaries in employee benefit plans, then a fund’s business model is totally irrelevant to the question of the prudence of a fund.
The terms “retirement readiness” and “financial wellness” are commonly referenced in ERISA circles. Those terms depend on the performance of a plan participant’s retirement account. The performance of a plan participant’s retirement account depends primarily on whether the investment options within a 401(k)/403(b) plan are cost-efficient.
Both the Restatement (Third) of Trusts (Restatement), as well as simple common sense, accept cost-efficiency as the true test of fiduciary prudence. After all, a mutual fund that is not cost-efficient results in a net loss for an investor, as it indicates that a fund’s incremental costs exceeds the fund’s incremental returns when compared to a fund with a similar objective, e.g., large cap growth, small cap value.
The court in the Citigroup case cited the significant difference in expense ratios between comparable Vanguard funds and the actively managed mutual funds in the Citigroup plan as a key reason that the court denied Citigroup’s motion to dismiss. Again, for ERISA to be meaningful, the courts must be consistent and equitable in interpreting and applying the statute.
The “Acceptable Range of Expense Ratios” Defense
If we accept the Restatement’s position as to the cost-efficiency standard for actively managed funds, then the suggestion of a legally acceptable range of annual expense fees, without consideration of the issue of “commensurate returns,” is fatally flawed. It also nullifies the notion that annual expense fees can ever be a matter of law since cost-efficiency is clearly fact specific, a matter of fact, not a matter of law. Courts may not properly grant motions to dismiss based on questions of fact, as questions of fact are exclusively the province of a jury.
There is no mention of the concept of universally acceptable ranges of expense ratios in ERISA. While a range of expense ratios may be acceptable in a particular case based upon the specific facts of that case, and the funds involved in that case may be cost-efficient, to suggest that the range of expense ratios in one ERISA action are equally acceptable in every ERISA action has no merit. The acceptability of a range of expense ratios in any case necessarily depends on the specific facts of each case.
In the second portion of the referenced Putnam quote, the court attempts to justify its decision by stating that the plaintiff failed to produce any rulings holding that the range of expense ratios in the action was unreasonable as a matter of law. The Restatement (Third) of Trusts states that the choice of actively managed mutual funds for retirement plans is only prudent if such funds can be reasonably predicted to produce commensurate returns to cover the extra costs and risks typically associated with managed funds, i.e., such funds are cost-efficient.
Studies have consistent shown that the majority of actively managed mutual funds are not cost-efficient.7 Many of those same studies state that the majority of actively managed funds fail to even cover their costs. Investment icon Charles Ellis summed it up best with his observation that
Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.”8
In short, there is not, and cannot be, any universally acceptable range of expense ratios. The prudence of a mutual fund’s expense ratio is a fact-specific issue, relative to a fund’s overall cost-efficiency. It is actually very simple-if a fund is not cost-efficient, then neither the fund nor its expense ratio is acceptable under either a fiduciary prudence or suitability standard.
The “Menu of Investment Options” Defense
Courts seem to really like this argument. The argument is that even if some of the investment options within a retirement plan are imprudent, the plan provided so many other options that a plan participant could have chosen a proper portfolio. The plans and the courts usually cite Hecker v. Deere & Co. (aka Hecker I) in support of their argument.9
For some reason, supporters of this argument conveniently fail to mention the court’s subsequent ruling in Hecker II.10 The court’s decision in Hecker I created such an uproar that the court issued a “clarification,” or what many feel was actually a reversal, of their earlier “menu of options” decision. The Hecker II decision made it clear that offering a large number of investment options does not insulate the plan or the plan’s fiduciaries from liability for the imprudent selection of such plan options.
ERISA courts have consistently rejected the so-called “menu of options” defense.11 One court in particular properly nullified the “menu of options” defense, stating that
Such a rule would improperly shift the duty of prudence to monitor the menu of plan investments to plan participants. The Seventh Circuit opined that such a standard ‘would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives’….[T]he fact remains ERISA charges fiduciaries like [plan sponsors and other plan fiduciaries] with ‘the highest duty known to the law,’ which includes the duty to prudently select investment options and the duty to act in the best interests of the plans.
Much as one bad apple spoils the bunch, the fiduciary’s designation of a single imprudent investment offered as part of an otherwise prudent menu of investment choices amounts to a breach of fiduciary duty, both the duty to act as a prudent person would in a similar situation with single-minded devotion to the plan participants and beneficiaries, as well as the duty to act for the exclusive purpose of providing benefits to plan participants and beneficiaries.”12
A Proposed Solution
The current trend of some ERISA court decisions being arguably inconsistent and inequitable, effectively denying plan participants the protections guaranteed them under ERISA, is simply unacceptable. I have identified some of the problems that I feel exist. Now I would like to propose a simple solution.
People that know me know that I am a strong advocate of the fiduciary standards set out in the Restatement, especially
- Section 90, comment b, regarding a fiduciary’s duty to control costs,
- Section 90, comment f, regarding a fiduciary’s duty to seek the highest return for a given level of cost and risk or, conversely, the lowest cost and risk for a given level of return, and
- Section 90, comment h(2), stating that the use or recommendation of actively managed mutual funds is imprudent unless the funds can objectively be predicted to provide returns that are commensurate with the added costs and risks, i.e., are cost-efficient
Since actively managed funds are still the predominant investment options within 401(k) plans and other types of retirement plans, a lot of the aforementioned problems could be prevented by simply adopting the Restatement’s cost-efficiency standard. Such a move would remove any subjectivity issues and would reduce the evaluation process to one simple question- is the fund cost-efficient? There is no “kinda” cost-efficient. It either is or it is not.
Adopting a cost-efficient standard would also prevent the “special” funds argument that was asserted by the defendants and accepted by the court in the NYU case. Since funds are required by law to disclose their returns and their costs, the information needed to calculate a fund’s cost-efficiency, there would be no “special” funds or special exceptions issues. The key question would simply be whether the fund in question is cost-efficient.
The investment industry and ERISA advisors would presumably oppose the adoption of a universal cost-efficiency standard. As noted earlier, most actively managed mutual funds are not, and cannot be, cost-efficient. Without even factoring in the issue of costs, Standard & Poor’s SPIVA reports consistently show that the overwhelming majority of actively managed mutual funds fail to beat their index-based benchmarks, precluding any possibility of a fund being cost-efficient.
Adopting a cost-efficiency standard would also address ERISA’s lack of an educational program requirement. An effective education requirement would allow participants to learn how to detect fiduciary beaches and imprudent investment options within their plan. That knowledge would also allow plan participants to effectively pursue “retirement readiness” and financial security, supposed goals of ERISA.
For my part, I have created several posts explaining my metric, the Active Management Value Ratio (AMVR). The AMVR is based largely on the studies of investment icons Charles Ellis and Burton Malkiel. The AMVR allows investors, fiduciaries and attorneys to determine the cost-efficiency of an actively managed mutual fund. The information required to calculate a fund’s AMVR is available online and only requires the basic skills of addition, subtraction, multiplication and division. I have even provided an AMVR worksheet online to simplify the calculation process. For more information about the AMVR, click here.
In my opinion, a number of the recent decisions dismissing 401(k)/403(b) excessive fees/breach of fiduciary duties are questionable, being based on grounds that are inconsistent with the Restatement (Third) of Trusts, a resource cited by Supreme Court as a key resource in deciding fiduciary issues, especially those involving ERISA. If ERISA is to be meaningful, then the interpretation and application of ERISA must be consistent and fair to ensure the protections enumerated in the statute.
The Restatement provides a simple and definitive standard for determining whether an ERISA fiduciary has breached their fiduciary duty of prudence in their selection of a plan’s investment options, the Restatement’s cost-efficiency standard. By adopting the cost-efficiency standard, the courts could eliminate most of the inconsistency and fairness issues that currently exist in some courts.
1.Bernaola v. Checksmart Financial, Inc., available online at https://www.bloomberglaw.com/public/desktop/document/Bernaola_v_Checksmart_Financial_LLC_et_al_Docket_No_216cv00684_SD/2?1536004555
2. Checksmart, supra.
3. 29 U.S.C.§ 1113.
4. Johnston v. CIGNA Corp., 916 P.2d 643, 646 (1996).
5. Hecker v. Deere & Co., 569 F.3d 708, 711(7th Cir. 2009).
6. Brotherston v. Putnam Investments, LLC, available online at https://www.bloomberglaw.com/public/desktop/document/JOHN_BROTHERSTON_and_JOAN_GLANCY_individually_and_as_representati/1?1536004808.
7. Putnam, supra.
8. Charles D. Ellis, “The End of Active Investing,” Financial Times, January 20, 2017
9. Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009).
10. Hecker v. Deere & Co., 569 F.3d 708, 711(7th Cir. 2009).
11. DiFelice v. U.S. Airways, 497 F.3d 410, 417, 418 fn. 8 423 (4th Cir. 2007) McDonald v. Edward D. Jones & Co., 2017 WL 372101; Kreuger v. Ameriprise Financial, Inc., 2012 WL 5873825; Pfeil v. State Street Bank & Trust Company, 671 F.3d 585, 587 (6th Cir. 2012).
12. Pfeil, supra, 957-598
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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.