Correlation of Returns: The ERISA 404(c) Fiduciary “X” Factor

I received an email the other day from a local 401(k) plan. The email was short and simple – “we would you like you to come and present your ‘404(c) Fiduciary Liability Circle’ presentation.” After I gave the presentation, I got the typical response from the plan’s investment committee – “how soon can we implement the program?”

Several courts have recently dismissed 401(k)/403(b) actions alleging excessive fees and/or a breach of fiduciary duties by a plan’s sponsor. These dismissals have resulted in various articles and social media posts predicting the end of such legal actions.

As Mark Twain reportedly said, “reports of my demise have been greatly exaggerated.” A closer look suggests that predictions of the end of 401(k)/403(b) litigation are extremely premature. Or, as I tell colleagues, “the Fat Lady is far from singing.”

I have posted several articles regarding my belief that too many investment fiduciaries and ERISA plans have overlooked Section 90, comments h(2) of the Restatement (Third) Trusts (Restatement).1 Comment h(2) essentially states that a fiduciary’s use of actively managed mutual funds that are not cost-efficient is imprudent.

The Restatement’s position is even more important given the various reports that have found that the overwhelming majority of actively managed mutual funds are not cost-efficient, as they cannot even cover their fund’s fees/costs.

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.2

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.3

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.4

During my presentation of the “401(k) Fiduciary Liability Circle,” I always ask a plan’s investment committee if they considered the correlation of returns between the funds under consideration for their plan. Typically, the answer is “no.” Did the plan’s service provider provide them with that information? Again, “no.” Did they ask the service provider to provide such information? About this time, I often get the question – “What is correlation of returns and why is it even important.”

ERISA Section 404(c)
Many 401(k)/403(b) plans elect 404(c) status, as it may insulate the plan and plan sponsors from liability for the actual performance of the plan’s investment options. However, there are over twenty requirements that must be met to qualify for 404(c) protection. Based on various reports, few plans ever qualify as a 404(c) plans.

Based on my experience, even fewer plans are actually aware of the language set out in ERISA regarding Section 404(c). Let’s change that.

(b) ERISA section 404(c) plans

(1) In general. An “ERISA section 404(c) Plan” is an individual account plan described in section 3(34) of the Act that:

(i) Provides an opportunity for a participant or beneficiary to exercise control over assets in his individual account; and

(ii) Provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his account are invested.5 (emphasis added)

So, to qualify for 404(c) protection, a plan must provide a plan participant or beneficiary with

(a) an opportunity to exercise control over the assets in their 401(k)/403(b) account; and (b) an opportunity to choose the investments for their account from a “broad range” of investment options.

So how does a plan satisfy the “exercise control” requirement?

(2) Opportunity to exercise control.

(i) a plan provides a participant or beneficiary an opportunity to exercise control over assets in his account only if:

(B) The participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed investment decisions with regard to investment alternatives available under the plan, and incidents of ownership appurtenant to such investments….6 (emphasis added)

So now we have the added requirement of a plan providing a plan participant or their beneficiary with “sufficient information to make informed investment decisions.” The obvious question is what constitutes “sufficient information?” ERISA 404(a)-5 specifies certain investment information that a plan must provide to plan participants for each investment option within a plan. A fund’s invest fees and expenses are among the information that must be provided.

Last question – how does a plan satisfy the “broad range” of investment options requirement?

(3) Broad Range of Investment Alternatives

(i) A plan offers a broad range of investment alternatives only if the available investment alternatives are sufficient to provide the participant or beneficiary with a reasonable opportunity to:

(A) Materially affect the potential return on amounts in his individual account with respect to which he is permitted to exercise control and the degree of risk to which such amounts are subject;

(B) Choose from at least three investment alternatives:

(3) Broad range of investment alternatives

(1) Each of which is diversified;

(2) Each of which has materially different risk and return characteristics;

(3) Which in the aggregate enable the participant or beneficiary by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary; and

(4) Each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant’s or beneficiary’s portfolio;

(C) Diversify the investment of that portion of his individual account with respect to which he is permitted to exercise control so as to minimize the risk of large losses, taking into account the nature of the plan and the size of participants’ or beneficiaries’ accounts. In determining whether a plan provides the participant or beneficiary with a reasonable opportunity to diversify his investments, the nature of the investment alternatives offered by the plan and the size of the portion of the individual’s account over which he is permitted to exercise control must be considered.7 (emphasis added)

Essentially what this section of 404(c) is doing is reinforcing the importance of controlling costs and risk management through effective diversification within an investment account. with providing plan participants and beneficiaries with a selection of investment options that allow them to effectively diversify their account in order to minimize the risk of large losses. In fact, the two primary themes you see throughout ERISA is the importance of providing plan participants with effective means to control costs and to minimize the risk of large losses.

Control costs. Minimize the risk of large losses.

Controlling Costs and Correlation of Returns
Controlling investment costs is obviously integral to controlling one’s 401(k)/403(k) account. The compounding of investment fees and expenses can significantly reduce an investor’s end return. Each additional 1 percent in fees and expenses reduces an investor’s end-return by approximately 17 percent over a twenty year period.

Actively managed funds continue to be the primary investment options offered within most 401(k)/403(b) plans, although reports are that pension plans are making some adjustments. However, as previously mentioned, a number of studies have found that most actively managed funds are not cost-efficient, as they cannot even produce incremental returns that cover their fees and costs.

This becomes even more troubling when one considers the studies regarding the current concern over “closet” or “shadow” indexing. Professor Ross Miller of the State University of New York/Albany did a study on the impact of closet indexing. His findings were extremely interesting.

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management.

In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment.

Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.8

What Professor Miller found was that when factoring in the correlation of returns between an actively managed mutual fund and a comparable index fund, actively managed funds often charge an effective annual expensive ratio that is often 500-600 percent higher than the fund’s publicly stated expense ratio.

So considering the correlation of returns between an actively managed mutual fund and a comparable, but less expensive, index fund can help plan participants and their beneficiaries to control costs. As the saying goes, “you get what you don’t pay for.” Less in the fund’s pocket means higher returns for an investor.

Risk Management and Correlation of Returns
Harry Markowitz won a Nobel Prize for developing the concept of Modern Portfolio Theory (MPT). While valid criticisms of MPT have been raised, MPT’s core concept of managing portfolio risk through effective diversification of a portfolio’s assets is still valid and valuable.

The key word is effective diversification. Too many investors mistakenly believe that choosing a number of mutual funds from different asset categories, i.e., large cap growth fund, small cap value fund, domestic bond fund, international fund, is effective diversification.

Markowitz correctly described effective diversification:

To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little more protection than the uncertain return of a single security.

Effective diversification depends not only on the number of assets in a trust portfolio but also on the ways and degrees in which their responses to economic events tend to reinforce, cancel or neutralize one another.9

So, factoring in the correlation of returns between the investments in a portfolio hopefully helps investors protect against large losses. No one can predict the performance of the stock market. However, 401(k)/403(b) plans that can show that they did factor in correlation of returns can show that they employed a prudent process in selecting a plan’s investments, as required by ERISA.

The investment industry often points out that ERISA does not specifically require that plan advisers and plan sponsors provide correlation of returns data to plan participants. It is also true that ERISA does not specifically prohibit plans and plan sponsors from providing such information either. Furthermore, ERISA specifically authorizes the provision of information about key investing concepts.

Correlation of returns information is essential in effectively diversifying an investment portfolio in order to avoid large losses, one of ERISA’s stated goals. Therefore, a  prudent  plan investment committee will have considered such information in properly performing the due diligence investigation and evaluation required by ERISA. Therefore, providing such information to plan participants would clearly impose no hardship or additional cost on the plan or the plan sponsors. Perhaps this is simply another emerging issue for future 401(k)/403(b) litigation.

Going forward
As I have suggested before, I believe that we are going to see the plaintiff’s bar begin to focus more on the issues of cost-efficiency and “closet” indexing in 401(k) excessive fees/breach of fiduciary duty actions. Mutual funds and plan service providers do not like to talk about cost-efficiency or “closet” indexing. Plan sponsors must insist on such information in order to properly both the plan and themselves against fiduciary liability.

The investment industry knows, and has known for some time, that most actively managed funds are neither cost-efficient nor prudent. In my opinion, that is why the investment industry has fought so strongly to prevent any true fiduciary standard from being adopted by the Department of Labor and the Securities and Exchange Commission.

That is why plan service providers often include fiduciary liability disclaimer language in their advisory contracts with pension plans. Many plans apparently do not closely read their advisory contracts. As a result, they are either completely unaware that such language is in their advisory contract or they do not truly understand the significance of such disclaimer.

401(k)/403(b) excessive fees/breach of fiduciary duty actions are not going away anytime soon. Nor should they, as these plans have sometimes been the victim of questionable, conflicted advice from their plan advisers. As a result, many plan sponsors are not truly aware of the extent of unlimited personal liability exposure they are facing or the changes that need to made within their plan.

Plans should never agree to an advisory contract that contains a fiduciary disclaimer clause. If the plan’s service provider does not have confidence in their advice, why should a plan sponsor?

For proactive investment fiduciaries and service providers, this presents a perfect opportunity to demonstrate their value added proposition to a plan. That is exactly why I created my “401(k) Fiduciary Liability Circle” presentations – “Why” and “How.” And yes, they are copyright protected.

Copyright © 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only. It 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.

1. Restatement (Third) Trusts, Section 90, cmt h(2). American Law Institute.
2. Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017.
3. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
29 CFR § 2550.404c-1(b)(1)
6. ERISA 29 CFR § 2550.404c-1(b)(2)
29 CFR § 2550.404c-1(b)(3)
Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” available at
Harry M. Markowitz, Portfolio Selection, 2nd Ed. (Cambridge, MA: Basil Blackwood & Sons, Inc., 1991), 5.

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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1 Response to Correlation of Returns: The ERISA 404(c) Fiduciary “X” Factor

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