The Cost-Efficiency Standard: Streamlining the ERISA 401(k)/403(b) Litigation Process

Any darn fool can make things bigger and more complex… It takes a touch of genius – and a lot of courage – to move in the opposite direction. – Albert Einstein

Simplicity is the ultimate sophistication. – Leonardo da Vinci

Do an actively managed mutual fund’s incremental returns exceed its incremental costs relative to a comparable index fund? Your basic Econ 101 cost/benefit analysis between two investment options. It’s just that simple.

The basic premise of ERISA is also simple:

ERISA is a comprehensive statute designed to promote the interests of employees and their beneficiaries in employee benefit plans.1

And yet, it could be legitimately argued that a number of recent court decisions dismissing 401(k)/403(b) plan participant actions have seemingly gone out of their way to protect the investment industry at the cost of the plan participants. One such case, Brotherston v. Putnam Investments, LLC, has already been vacated by the First Circuit Court of Appeals.2  Putnam has filed a petition for a writ of certiorari with SCOTUS, asking the Court to review the First Circuit’s decision.

My point in mentioning these cases is simply to suggest that in some of the recent dismissals involving 401(k)/403(b) actions, it seems that the courts involved have based their decisions on irrelevant, corollary issues, while totally losing sight of ERISA’s stated purpose-protection of a plan’s participants.

SCOTUS has recognized the legitimacy of the Restatement of Trusts in resolving fiduciary legal questions, especially those involving ERISA.

We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts. In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts.’3

Section 90 of the Restatement (Third) of Trusts (Restatement) sets out several relevant standards in determining whether a fiduciary has fulfilled its fiduciary duty of prudence, including

  • A fiduciary has a duty to be cost-conscious.4
  • In selecting investments, a fiduciary has a duty to seek either the highest level of a return for a given level of cost and risk or, inversely, the lowest level of cost and risk for a given level of return.5
  • Due to the impact of costs on returns, fiduciaries must carefully compare funds’ costs, especially between similar products.6
  • Due to the higher costs and risks typically associated with actively managed mutual funds, a fiduciary’s selection of such funds is imprudent unless it can be shown that the fund is cost-efficient.7

At the end of the day, I would argue that adopting a cost-efficiency standard would greatly streamline the litigation of 401(k)/403(b) actions by eliminating the consideration of irrelevant corollary issues, while at the same time furthering ERISA’s stated mission of protecting plan participants. If the goal of 401(k) and 403(b) plans is truly to protect and promote the “best interests” of plan participants as they work toward “retirement readiness,” the cost-efficiency of a plan’s investment options should be of primary concern.

Adopting a cost-efficiency standard as the preliminary and primary prudence standard in 401(k)/403(b) fiduciary breach actions would have streamlined the litigation process, and arguably ensured a fair and equitable outcome, in some recent actions by avoiding irrelevant issues such as a mutual fund’s business platform, the popularity of an actively managed fund, a fund’s amount of assets under management, and the legal recognition of a particular range of expense ratios within a plan based on absolute numbers alone.

By adopting a cost-efficiency standard as the preliminary and primary prudence standard in 401(k)/403(b) fiduciary breach actions, the court and the parties would only have to answer one simple two-part question:

At the time that the plan sponsor selected a particular actively managed fund for the plan:
(a) was the actively managed mutual fund cost-efficient in comparison to other comparable available funds, including index funds, and
(b) did the actively managed mutual fund further ERISA’s goal of properly protecting  the plan participants’ best interests and providing them with the best opportunity to work toward “retirement readiness?”

That simple two-part question would address the burden of proof issues regarding both fiduciary prudence and causation of damages.Meaningless corollary issues, such as the “apples to oranges” and the concept of legally approved ranges of expense ratios arguments discussed in Brotherston and the “uniqueness” argument that has been put forth in various cases involving TIAA-CREF investments could be avoided.

Removing meaningless corollary issues from 401(k)/403(b) actions would simplify the issues for trial or settlement, by allowing the court and the parties to properly focus on the bottom line in ERISA actions-a fund’s performance relative to the costs incurred and the true impact on plan participants. As a former litigator, I can imagine conducting both direct examinations and cross-examinations in a case by just going through a plan’s list of actively managed funds and simply asking the plan sponsor and all the experts-cost-efficient or cost-inefficient?

Studies by well-respected investment experts and academicians have consistently found that the overwhelming majority of actively managed mutual funds are not cost-efficient.8 Actively managed funds typically have higher annual fees and higher trading costs than comparable index funds. An active fund’s only hope of covering those higher costs and fees is to outperform the comparable index fund.

But recent data suggests that more actively managed funds are currently guilty of “closet” or “shadow” indexing comparable index funds in order to avoid significant variances between the their returns and the index fund’s returns.  The obvious fear is that such variances could result in the active fund’s customers moving their accounts to the comparable, less expensive index funds. But such “closet” indexing only ensures that an actively managed fund will continue to be cost-inefficient relative to a comparable, less expensive, index fund.

Going Forward
Does an actively managed mutual fund’s incremental returns exceed its incremental costs relative to a comparable index fund?

It’s just that simple. However, actively managed funds do not like to address the issues of cost-efficiency or “closet” indexing for obvious reasons. For some reasons, the lack of cost-efficiency of actively managed mutual funds is an issue that is not often addressed in the media.

And yet, the inclusion of so many cost-inefficient actively managed mutual funds is effectively preventing plan participants from having any hope of achieving the full extent of potential “retirement readiness” that they could possibly have with cost-efficient funds. As a result, ERISA’s stated purpose is being effectively denied.

By definition, mutual funds that are cost-inefficient can never qualify as a prudent investment. Investments whose relative costs exceed their relative returns are never prudent investments. Or, as the commentary to Section 7 of the Uniform Prudent Investor Act states, “wasting beneficiaries’ money is imprudent.”

The Restatement also establishes the imprudence of cost-inefficient actively managed mutual funds.  That is why the courts should adopt cost-efficiency as both a preliminary and primary standard in deciding ERISA cases alleging a breach of a fiduciary’s duty of prudence. Prudent and proactive plan sponsors would be wise to also apply cost-efficiency as their preliminary and primary screens in selecting investment options for their plans, thereby minimizing the chance of unwanted and unnecessary fiduciary liability exposure for themselves.

A couple of years ago I created a simple metric, the Actively Management Value Ratio™ (AMVR), that allows investment fiduciaries, investors, and attorneys to evaluate the cost-efficiency of mutual funds. Based on the findings and concepts of investment experts such as Nobel Laureate Dr. William D. Sharpe, Charles D. Ellis and Burton G. Malkiel, the AMVR uses a  minimal amount of data, all of which is freely available online, and only requires the basic math skills we all learned in elementary school (My Dear Aunt Sally-multiplication, division, addition and subtraction). For additional information on the AMVR and the required calculation process, click here.

One could argue that the First Circuit’s opinion in Brotherston v. Putnam Investments, LLC implicitly, if not expressly, validated cost-efficiency as both a preliminary and primary standard in 401(k)/403(b) fiduciary prudence actions, stating that

More importantly, the Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.’9

As noted ERISA attorney Fred Reish likes to say, “forewarned is forearmed.”

Notes
1. Shaw v. Delta Airlines, Inc., 463 U.S. 85, 90 (1983).
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018).
3. Tibble v. Edison International, 135 S. Ct 1823 (2015).
4. Restatement (Third) Trusts, Section 90, cmt. b (American Law Institute).
5. Restatement (Third) Trusts, Section 90, cmt. f (American Law Institute).
6. Restatement (Third) Trusts, Section 90, cmt. m (American Law Institute).
7. Restatement (Third) Trusts, Section 90, cmt. h(2) (American Law Institute).
8. Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e; Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE, 179, 181 (2010); Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016; Mark Carhart, “On Persistence in Mutual Fund Performance,” 52 J. FINANCE, 52, 57-8 (1997).
9. Brotherston, at 39.

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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