ERISA Risk Management and the Forensic ERISA Attorney

I was at a reception last week when someone asked me the question I love to hear – “so, what do you do for a living?”

“I am a forensic ERISA attorney.”

Head tilt, accompanied by polite stare.

“I reverse engineer 401(k) and 403(b) plans.”

Head tilt, to the other side, polite stare.

Then I smiled and told them that I analyze 401(k) and 403(b) plans and, if needed, design “win-win” plans that provide plan participants with meaningful “retirement readiness” investment options, while also reducing the fiduciary risk of the plan and the plan fiduciaries. That explanation usually results in more questions and an interesting discussion. People may not like attorneys, but EVERYONE like to talk money and their retirement accounts.

Life’s too short not to have a little harmless fun. A friend of mine in PR suggested the “branding” title a couple of months ago. I’ll be paying her and her husband’s green fees for the awhile.

Interestingly enough, many people tell me that they may not remember my name after a meeting or event, since they meet so many people, but they always remember my title and what I do – “forensic ERISA attorney.” I often get several follow-up calls and/or emails after a meeting or an event. Again, people care about money and their retirement accounts. Plan sponsors care about avoiding, or at least reducing, any potential personal liability.

I have already posted several articles about the Putnam Investment, LLC v. Brotherston case and Putnam’s petition asking SCOTUS to hear their case. At this point, SCOTUS has not indicated whether it will hear the case.

I believe that we are at a pivotal point in the ERISA arena. Putnam is asking SCOTUS to reverse the First Circuit Court of Appeals decision in which the court ruled that once a plaintiff/plan participants shows that a plan violated its fiduciary duties under ERISA, the plan they has the burden of proving that the investments they chose for their plan did not cause the plan participants’ losses. (The SCOTUS filings are available here.)

If SCOTUS does grant certiorari and decides to uphold the First Circuit’s decision, or declines to hear the case at all, then Putnam will  have the burden of proof on causation. I believe that the implications of that burden extend well beyond the immediate case.

The Cost-Efficicency Question
Based on the research of numerous noted and well-respected investment experts, the evidence overwhelmingly shows that most actively managed mutual funds are cost-inefficient, that they fail to cover their investment costs.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.1

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

These findings should not really come as a surprise to anyone. Actively managed funds typically have higher costs than comparable index funds due to higher management fees and higher trading costs. The challenge for actively managed funds is to then justify such higher fees/costs by producing higher returns for investors.

However, there seems to be an increasing trend of some actively managed funds choosing to essentially “track” the performance of a comparable index funds in order to avoid a significant deviation for the index fund’s performance. By avoiding significant differences in returns, actively managed funds hope to avoid the potential loss of clients.

However, this strategy of holding a fund out as being actively managed and charging higher fees for such purported services, while essentially providing the same returns as a comparable, yet less expensive, index funds is generally referred to as “closet” or “shadow” indexing. While “closet” indexing may reduce the risk of variances in returns, it effectively ensures the cost-inefficiency of the actively managed mutual fund involved, since there will be little chance of the active funds making up the cost differential between the active and the passive fund.

The issue of “closet” indexing is not just a U.S. phenomena. Canada and Australia have been among the leaders in addressing the problem. Questions are now being raised in the U.S. and internationally as to whether the strategy constitutes a securities violation since investors are not effectively receiving the services they were led to believe, at least to the extent they were led to believe.

At the end of each calendar quarter, I prepare a forensic analysis of the top ten non-index funds in U.S. defined contribution plans, based on “Pensions & Investments” annual survey. The analysis for the 1Q 2019 showed that all  ten of the funds had a R-squared correlation score of over 90. This means that 90 percent or more of the ten funds’ five-year returns could be attributed to the performance of a relevant market index or index fund, rather than the contribution’s of the funds’ active management team. (InvestSense uses a five-year return period for analyses to reduce the chance of skew.)

My posts on the Brotherston decisions have resulted in a number of inquiries from pension plans asking me what they need to do and how to do it to reduce potential liability exposure. Since ERISA liability is based on past events over the last three or six years, there is nothing that can be done to avoid or minimize liability for past acts.

While no one knows what SCOTUS may do on the pending petition for cert, the good news is that regardless of the Court’s eventual decision, the prudent choice would be for plans and plan service providers to act proactively to ensure that their plan’s investment options are prudent and cost-efficient going forward, and to regularly monitor the plan’s investments, replacing those that are no longer cost-efficient. The ability to show that the plan had a fundamentally sound due diligence program in place and actually followed such system would be valuable in responding to any audits and/or ERISA claims that might arise.

Existing Legal Precedents
In closing, in my practice I offer ongoing fiduciary oversight services to make sure that plans are in, and remain in compliance with ERISA and up-to-date on industry trends. At the beginning of the year I always remind them of some basic 401(k)/403(b) risk management principles:

  • Monitor your plans’ investment options to ensure that they are cost-efficient and otherwise “objectively prudent,” including following the guidelines set out in the Restatement (Third) of Trusts. I recommend at least two plan prudence reviews annually. In defining “objective prudence,” with regard to defined contribution plans, the courts have stated that

    [T]he determination of whether an investment was objectively imprudent is made on the basis of what the [fiduciary] knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate.(emphasis added)

    Here the relevant ‘portfolio’ that must be considered is each available fund considered on its own…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 another investment option], could have theoretically, in combination, created a prudent portfolio.(emphasis added) 

  • Plan fiduciaries cannot blindly rely on plan service providers or other third parties. ERISA requires that plan sponsors and other plan fiduciaries conduct their own independent and objective investigation. The failure of a plan’s fiduciaries to do so is a per se breach of their fiduciary duties.
  • While plan fiduciaries are allowed, even encouraged, to retain expert if the fiduciaries lack the experience or knowledge to select and monitor the plan’s investment options, the selection of and any reliance on such experts must be “reasonable” in order to be legally justified.  So the obvious question is what constitutes “reasonable.” In defining the “reasonable” requirement regarding the selection of and reliance on experts the courts have consistently stated that

One extremely important factor is whether the expert advisor truly offers independent and impartial advice….7  (emphasis added)

Plans sponsors will often tell me that they do not have time to deal with “all these rules;” that if they get audited or sued, they will simple say they did not know and/or understand ERISA’s rules. For any plans or plan sponsors considering such strategies, I offer two time-honored legal quotes:

ignorance of the law is no defense, and

a pure heart and an empty head are no defense [to a claim of the breach of one’s ERISA’s fiduciary duties.]8

Going Forward
I do believe that the Brotherston case is a potential turning point for 401(k)/403(b) plans, as the evidence strongly suggests that they will not be able carry the burden of disproving that  actively managed mutual funds in their plan caused plan participants to suffer financial losses due to the relative cost-efficiency of the active funds. Furthermore, unless the mutual fund industry makes dramatic, and highly unlikely, changes in their current business platforms, it is unlikely that 401(k) and 403(b) plans that continue to opt for actively managed mutual funds as investment options within their plans will be able to meet the challenge of the burden of proof on causation going forward.

Just my opinion based on the overwhelming evidence. The situation reminds me of two quotes –

Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened. – Winston Churchill

It is difficult to get a man to understand something when his salary depends upon his not understanding it. – Upton Sinclair

Meanwhile, we anxiously await SCOTUS’ decision.

1. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE, 179, 181 (2010).
2. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at 
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,  52 J. FINANCE, 52, 57-8 (1997)
5. Fink v. National Sav. and Trust Co., 772 F.2d 951, 962 (D.C.C. 1984).
6. DiFelice v. U.S. Airways, 497 F.3d 410, 423 and fn. 8.
7. Gregg v. Transportation Workers of America Intern., 343 F.3d 833, 841 (6th Cir. 2003).
8. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983)

© Copyright 2019 The Watkins Law Firm. 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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