Designing a “Win-Win” 401(k)/403(b) Defined Contribution Plan

As a forensic ERISA attorney. I use forensic analysis to demonstrate effective risk management strategies to pension plans. I also design liability-driven, “win-win,” 401(k) and 403(b) plans (hereinafter “401(k) plans”). “Win-win” 401(k) plans are plans that provide plan participants with a meaningful opportunity to work toward “retirement readiness,” while at the same minimizing the potential fiduciary liability of the plan and the plan fiduciaries.

The 401(k) Litigation Landscape
The 401(k) landscape has seen an increase in the amount of litigation alleging improper management of 401(k) plans. Most legal actions involving such plans have alleged excessive fees and/or a breach of the plan’s fiduciary duties with regard to the selection and/or monitoring of the plan’s investment options.

I am on record as saying that I believe that 401(k) excessive fee/fiduciary breach cases are not going to end anytime soon. My opinion is based on my experience auditing and analyzing 401(k) plans. Most plans I have seen are simply not ERISA compliant, for reasons I will address in this white paper.

As a result, I believe it is more important than ever for plans and plan fiduciaries to become more proactive in ensuring that their plans are ERISA compliant. Whether this simply requires a better system of selecting and monitoring a plan’s investment options, or designing and implementing a “win-win” plan, taking a more proactive position in managing a plan can help both plan participants and plan fiduciaries.

Creating a “Win-Win” 401(k)/430(b) Plan
I provide ERISA consulting services to 401(k) plans and ERISA attorneys. Whenever a potential ERISA client contacts me for the first time, I always ask two questions:

How many investment options are within the plan?
How many of the investment options are actively managed mutual funds?

Those two simple questions provide a wealth of information with regard to potential fiduciary liability exposure for a 401(k) plan and plan fiduciaries.

1. Number of Investment Options – Less is More
Most 401(k) plans that I have reviewed have mistakenly adopted the “more is better” approach in designing their plans. However, in the ERISA defined contribution arena, the number of investment options offered within a plan simply increases the potential fiduciary liability exposure for both the plan and the plan fiduciaries.

What some ERISA fiduciaries do not realize is that there are two separate and distinctly different fiduciary prudence standards for defined benefit and defined contribution plans. The fiduciary prudence standard for defined benefit plans is “the portfolio as a whole.” The fiduciary prudence standard for defined contribution plans is “each individual investment.”1

The rationale behind the difference is simple. In defined benefit plans, the plans carry the burden of investment risk. The plan has to make the required payments to the plan participants, regardless of the performance of the plan’s portfolio.

In defined contribution plans, the plan has the potential liability to shift the burden of investment risk to the plan participants. Since the plan is still responsible for selecting a defined contribution plan’s investment options, each individual investment needs to be prudent. As one court explained,

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.2 (emphasis added)

The “each investment” prudence standard for defined contribution obviously makes a “less is more” approach more prudent for a defined contribution plan, as the odds of non-compliance go up with each additional investment option. Simple statistics.

Advisers and plan sponsors often tell me that ERISA requires them to offer a large number of funds. But exactly what does ERISA require?

  • That plan sponsors manage the plan “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.3
  • That plan sponsors diversify the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.4

So far, ERISA Section 404 does not provide any real specifics about any quantitative requirement regarding mutual funds and a plan sponsor’s duty of prudence. Many defined contribution plans decide to elect Section 404(c) status in an attempt to shift investment risk to plan participants. Section 404(c) sets out approximately twenty requirements in order for a plan to qualify for the protections provided by the Section, among them that a plan provide participants with “an opportunity to choose, from a broad range of investment alternatives.”5

The Section then goes on to discuss the “broad range of investment alternatives” requirement:

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;6

(B) Choose from at least three 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;7

(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….8

So with regard to ERISA’s quantitative requirements for 401(k)/404(c) funds, ERISA expressly only requires a minimum of three funds. ERISA does require that the funds selected meet additional qualitative requirements, which we will address in the next section. But for right now, a plan could theoretically comply with both ERISA Sections 404(a) and 404(c) using just three funds.

In one of my earlier books, I suggested a format for a simple 401(k)/403(b) plan using just three diversified index funds. While I still believe that a legally compliant three index fund 401(k) plan is possible,  I believe a five index funds plan is more practical for a fund focusing on legal compliance, simplicity and “retirement readiness” effectiveness for plan participants.

The bottom line for plan sponsors and plan service providers is that ERISA does not require an army of funds in order to be ERISA compliant. In fact, a simpler plan offering a lower number of investment options is arguably in the plan participants’ best interests, as it makes the entire 401(k) participation process less intimidating, thereby avoiding the so-called “paralysis by analysis” concern.

However, the issue of quantitative prudence is just one aspect of designing a prudent “win-win” 401(k) plan.  Plan designers also need to focus on ERISA’s qualitative requirements. Two dominant themes throughout ERISA Section 404 are risk management, more specifically the avoidance of large losses, and cost-control/cost-efficiency

2. Risk Management, Diversification and Fiduciary Prudence
In terms of risk management, the Department of Labor and the courts have adopted Modern Portfolio Theory (MPT) as the method of assessing fiduciary prudence under ERISA. While MPT has drawn criticism for a number of valid reasons, MPT’s core concept, the value of effective diversification in avoiding large losses, is fundamentally sound.

Some plans and plan sponsor have attempted to justify an overabundance of investment options within a plan based on their belief that effective diversification requires that a large  number of investment options offered within a plan. However, Nobel Laureate Harry Markowitz, the creator of MPT, has clearly refuted that belief, stating that

It is not enough to invest in many securities. It is necessary to avoid investing in securities with high [correlations]among themselves….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

Furthermore, as the Restatement points out, effective diversification is a two-step process. Effective diversification requires both horizontal diversification (across asset classes) and vertical diversification (within asset classes).

Unfortunately, it has become increasingly harder to find equity-based funds mutual funds that offer the level of correlations of return necessary to effectively diversify a plan’s investment options, both in terms of domestic and international funds. But that does not relieve a plan’s fiduciaries of their duty of prudence in designing and monitoring their plan and its investment options.

3. Actively Managed Mutual Funds, Cost-Efficiency and Fiduciary Prudence
ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.10 The Restatement states that actively managed mutual funds are not prudent unless they are also cost-efficient.11

Most current 401(k) plans are still heavily dominated by actively managed mutual funds as their investment options. As mentioned earlier, various studies by academia and well-respected investment experts have consistently concluded that actively managed mutual funds are not cost-efficient, and therefore not prudent investment options.

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.12
  • 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.13
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.14
  • [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.15

The challenge for actively managed mutual funds is one described by the late Jack Bogle as “humble arithmetic.” Actively managed mutual funds typically have significantly higher expense ratios and higher turnover/trading costs than comparable index funds.

Therefore, in order to cover such costs and compete with comparable, less expensive index funds, the actively managed funds must outperform the index funds. However, studies have shown that many actively managed funds have adapted a “closet” or “shadow” indexing strategy in order to prevent significant variances in returns, which could result in a loss of customers.

Closet indexing is generally defined as an actively managed mutual fund advertising that it actively manages the fund’s assets, supposedly to provide better performance. In reality, closet indexing essentially guarantees that an actively managed fund will provide returns that are similar to, or often less than, those of a comparable index fund.

So, in essence, the actively managed fund owner has simply purchased an over-expensive, underperforming index fund. When forensic analysis is applied to such funds to factor in the actively managed fund’s R-squared/correlation of return number, the negative impact on an investor is even worse.  The negative impact on a fund’s end-return obviously increases the potential fiduciary liability exposure for a plan and the plan’s fiduciaries.

Interestingly, very few courts decisions have focused on the relationship between cost-inefficient performance and fiduciary prudence. Instead, recent court decisions dismissing 401(k) excessive fees/breach of fiduciary actions have cited a litany of theories to support their decisions, including

  • the difference in business platforms between actively managed funds and passively managed index funds (“apples to oranges”);
  • the “menu” or number of investment options offered by a plan;
  • the supposed legal acceptability of a range of fund expense ratios; and
  • the number of plans offering a specific fund.

If we accept the stated purpose of ERISA, to protect plan participants, and thus their ability to work toward “retirement readiness,” then all of the referenced theories are totally irrelevant. The only concern and question in 401(k) breach of fiduciary duty litigation should be whether an investment option in a 401(k) plan provides the plan’s participants with the best opportunity for carrying out ERISA’s stated purpose.

The Active Management Value Ratio™ 3.0
Recognizing the inherent compliance challenges involved with 401(k) plans , I created a metric, the Active Management Value Ratio™ (AMVR). The AMVR is based upon the research and investment management concepts of Nobel Laureate William D. Sharpe and investment icons Charles D. Ellis and Burton G. Malkiel. Both Sharpe and Ellis advocate the analysis of actively managed mutual funds by comparing such funds with comparable index funds.

Malkiel’s research found that a fund’s expense ratio and its trading costs are the most reliable predictors of a fund’s future performance. There are those who argue that factoring in a fund’s trading costs is misleading since trading costs are deducted as part of a fund’s operating expenses in calculating a fund’s performance.

While technically true, the law does not require that a fund specifically disclose the fund’s actual trading costs. This prevents a plan sponsor and plan participants from including a material fact in the selection of funds for the plan and their personal 401(k) accounts.

For example, assume a plan sponsor or plan participant is choosing between two funds with similar returns. However, one of the funds has a turnover rate that is significantly higher than that of the comparable index fund. All things being equal, the fund with the much lower turnover ratio is obviously the more cost-efficient option, and thus the more prudent investment choice.

Therefore, it can be legitimately argued that the fiduciary duty of prudence requires that a fund’s turnover/trading costs, or some acceptable proxy for such costs, be separated out of a fund’s operating costs and factored into a plan’s investment selection process. The fact that an actively managed fund’s turnover/trading costs are often significantly higher than the fund’s annual expense ratios only strengthens this argument.

For those reasons, the AMVR calculates an actively managed fund’s AMVR score based on both an expense ratio-only basis and a combined “expense ratio+trading costs” basis so that plans and ERISA attorneys can decide for themselves as to which analysis to use in their fiduciary prudence analyses. I supplement AMVR calculations with two additional proprietary metrics, the Cost–Efficiency Quotient (CEQ) and the Fiduciary Prudence Score. The Fiduciary Prudence Score provides an overall evaluation of an actively managed mutual fund’s efficiency, in terms of both risk management and cost-control, and the fund’s consistency of performance.

The AMVR calculation process is simple, requiring only the basic mathematic skills everyone learned in elementary school, “My Dear Aunt Sally”-multiplication, division, addition and subtraction. The AMVR requires a minimum amount of data, most of which is freely available online at sites such as Morningstar, Marketwatch and Yahoo! Finance. For more information about the AMVR and the calculation process required, click here. For an example of a typical AMVR report, click here.

As mentioned earlier, the evidence clearly shows that the overwhelming majority of actively managed mutual funds are not cost-efficient relative to comparable index funds. Cost-inefficient investments waste plan participants’ money. As the Uniform Prudent Investor Act states, “Wasting beneficiaries’ money is imprudent.”16

Going Forward
There are no signs that the level of 401(k) excessive fees/breach of fiduciary duty litigation is going to slow down anytime soon. In fact, as the information in this white paper has shown, there is every reason to believe that the level of litigation may actually increase.

This would be especially true if SCOTUS agrees to hear the Brotherston case and rules that pension plans have the burden of proof regarding causation in 401(k) litigation. As discussed herein, plans would seemingly be hard-pressed to successfully carry that burden of proof on most actively managed funds.

When I discuss the need for plans to design “win-win” 401(k) plans, many plan sponsors will indicate that they are not concerned about being sued or any potential liability because their plan is too small and/or their employees are happy with their plan and would never sue the company.

That may be; however, most 401(k) litigation is begun by former employees. Furthermore, under ERISA, so-called “alternate payees” have the same legal rights as the plan participants, including the right to sue a plan. The most common forms of alternate payees under ERISA are heirs and ex-spouses, who often acquire an interest in a plan as a result of a property settlement.

As many probate and divorce attorneys are quickly learning, a failure to properly evaluate and factor any 401(k) plan interests into probate or divorce proceedings may constitute legal malpractice. Consequently, it would not be surprising to see an increase in 401(k) litigation involving alternate payees’ interests in the near future.

While this white paper has focused on 401(k) plans and plan sponsors, the points made herein are equally applicable to plan service providers. Over the past year or so we have seen more ERISA-related complaints include plan service providers as party defendants.

Many plan sponsors mistakenly believe that the inclusion of a fiduciary disclaimer clause in their advisory contract insulates them from any liability whatsoever for the advice they provide to a 401(k) plan. Plan service providers are now learning that fiduciary disclaimer clause notwithstanding, they can still be sued by plans and plan participants for bad advice under common law principles such as negligence and breach of contract.

In conclusion, I often read stories defining the “perfect” 401(k)/403(b) plan in terms of the plan’s rate of participation, rate of retention and level of deferral/contribution. To me, that seems like “putting the cart before the horse.” What good are high participation rates and the like if at the end of the day the plan is writing a multi-million dollar check to settle a 401(k) fiduciary breach action?

Perhaps it is because I am an attorney, but it seems to me that the “perfect” 401(k)/ 403(b) plan is one that is designed to create a “win-win” situation for all parties involved with the plan – one that provides plan participants with a meaningful opportunity to work toward achieving “retirement readiness,” while protecting plan sponsors and other plan fiduciaries against unnecessary and unwanted fiduciary liability. Until a 401(k)/403(b) plan’s house is in order in terms of ERISA compliance, adding or retaining plan participants would seem to just be increasing the potential liability for the plan and the plan’s fiduciaries.

1. DiFelice v. U.S. Airways, 497 F.3d 410423 and fn. 8.
2. DiFelice.
3. 29 U.S.C.A Section 1104(a)(1)(B).
4. 29 U.S.C.A Section 1104(a)(1)(C).
5. 29 CFR § 2550.404c-1(b)(1).
6. 29 CFR § 2550.404c-1(b)(3)(i)(A).
7. 29 CFR § 2550.404c-1(b)(3)(i)(B)(1)-(4).
8. 29 CFR § 2550.404c-1(b)(3)(i)(C).
9. Harry M. Markowitz, Portfolio Selection, 2nd Ed. (Cambridge, MA: Basil Blackwood & Sons, Inc., 1991), 5-6.
10. Tibble v. Edison International, 135 S. Ct 1823 (2015).
11. Restatement (Third) Trusts, Section 90, cmt. h(2) (American Law Institute).
12 Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
13. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at 
14. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
15. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
16. UPIA, Section 7 (Introduction).

© 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™ 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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