Plan Sponsor Special Report: 401(k) Fiduciary Liability Risk Management in a Post-Brotherston World

My firm, InvestSense, provides fiduciary oversight services to pension plans, trust, and other investment fiduciaries. One of the most requested services is a fiduciary audit, including a forensic fiduciary prudence analysis of the entity’s investments.

After a recent audit, the company’s CEO and legal counsel asked me why no one had ever warned me of the issues I had identified. They agreed with all my findings, but were angered about the potential liability they faced due to poor advice they had received from others. They suggested that I write an article warning plan sponsors and other investment fiduciaries of these fiduciary issues, what I like to call “gotchas,” so as to avoid unwanted, and unnecessary, liability exposure. So I have.

Based upon my experience, there are four key fiduciary liability issues that most plans and plan sponsors need to address in the post-Brotherston 401(k) world:

  1. Cost-inefficiency of the plan’s investment options;
  2. Prudence of each individual investment option within the plan;
  3. Legal rules regarding reliance on third-parties; and
  4. Available recourse for poor investment advice provided to a plan.

1. Cost-Inefficiency of Plan’s Investments
I am sometimes contacted by ERISA plaintiff’s attorneys asking about the ERISA litigation strategy I have recommended since the First Circuit’s Brotherston decision. The strategy, which I refer to as BRIC, can also be used by investment fiduciaries to evaluate the legal soundness of their plan/trust.

“B” stands for Brotherston, and the recommendation to incorporate the excellent legal analysis of the application of fiduciary law that the First Circuit provided. Investment fiduciaries would also be wise the heed the court’s suggestion that

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 incurred as a result.(1)

Interestingly enough, John Langbein, the reporter for the committee that drafted the Restatement (Third) of Trusts, had expressed a similar warning in 1976, stating that

When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.(2)

The opinions expressed by both the First Circuit and Langbein are further supported by a 2007 article co-authored by K.J. Martijn Cremers and Quinn Curtis. Cremers, dean of the Notre Dame Mendoza School of Business, and Curtis, at that time an associate professor of law at the University of Virginia School of Law, questioned just how much active management “active” funds truly provided and the resulting financial and legal implications of same.

The authors cited  a 2007 presentation in which the general counsel of the SEC raised the following issues regarding the high correlation between “active” funds and comparable index funds:

[I]nvestors in some of these [funds] …are paying the costs of active management, but getting instead something that looks a lot like an overpriced index fund. So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether they’re getting the desired bang for their buck.(3)

Following up on that statement, Cremers, creator of the concept of Active Share, and Curtis concluded that

a large number of funds that purport to offer active management and charge fees accordingly , in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by for fees for active management that they do not receive or receive only partially. .

Closet indexing raises important legal issues. Such funds  are not just poor investments; they promise investors a service that they fail to provide. As such, some closet index funds may also run afoul of federal securities laws.(4)

Studies have consistently noted the same inequitable cost-return, i.e., cost-inefficiency, issues with actively managed funds, producing findings such as

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.(5)
  • [I]ncreasing 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.(6)
  • [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.(7)
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.(8)

With Brotherston placing the burden of proof regarding causation on plans, these consistent findings of cost-inefficiency regarding actively managed funds will make it very difficult for plan sponsors to meet such a burden, As a result, I believe we will see an increase in 401(k) fiduciary prudence litigation and more multi-million dollar settlements.

2. Prudence of each individual investment option within the plan
One of the most common mistakes plan sponsors make is evaluating their plan’s investment options in terms of the portfolio as a whole, instead of evaluating the prudence of each individual investment. This is clearly inconsistent with court decisions involving defined contribution plans and ERISA itself.

The notion of the “portfolio as a whole” concept relative to defined contribution  plans has been consistently rejected by the courts.

A fiduciary cannot avoid liability for offering imprudent investments merely by including them alongside a larger menu of prudent investment options. 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. (9)

Many plan sponsors and plan advisory point to the initial decision in Hecker v. Deere & Co. (Hecker I), as supporting the idea that the prudence of a plan’s investment options is judged by looking to the investments options as a whole, the so called investment menu” defense. (10) What they seem to forget is that the court went back and quickly issued what they deemed a clarification of their first decision after it drew widespread criticism for the suggestion that plans could insulate themselves by simply offering a lot of investment options.(11)

In Hecker II, the court stated that it neither intended to nor did suggest that a plan could avoid liability simply based on the number of fund options offered by the plan. The court expressly rejected any notion that a plan fiduciary “can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them.. The court also noted that such a position “would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives.”

The fallacy of the “plan investment menu” defense was further explained in the DiFelice v. U.S. Airways, Inc. decision, with the court explaining that

Under ERISA, the prudence of investments or classes of investments offered by a plan must be judged individually.” 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.(12)

The “R” in my BRIC concept stands for the Restatement (Third) of Trusts (Restatement). SCOTUS recognized that the courts often look to the Restatement for guidance in resolving fiduciary questions.(xx) The Restatement establishes a number of fiduciary standards with regard to a fiduciary’s duty of prudence. Three of the key standards are

  • a fiduciary has a duty to be cost-conscientious in investing.(13)
  • a fiduciary has a duty to seek the highest return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of return.(14)
  • that due to higher costs and risks associated with actively managed funds, actively managed funds are imprudent unless it can be objectively estimated that the funds will provide a commensurate return for the additional costs and risks incurred, i.e., are cost-efficient.(15)

In determining whether an ERISA fiduciary has breached their fiduciary duty of prudence, the courts assess the fiduciary’s action in terms of both procedural and substantive prudence.(16) In evaluating procedural prudence, the courts look at the methodology tht the fiduciary used, not he eventual results.(17) In evaluating substantive prudence, the courts base their decision on what the fiduciary knew or should have known.(18)

As the previously mentioned studies and comments have shown, most actively managed funds fall short of meeting even one of the Restatement’s requirements for fiduciary prudence.

The “I” in BRIC stands for InvestSense.  I created a simple metric, the Active Management Value Ratio (AMVR), that plan sponsors, trustees and attorneys can use to quickly calculate the cost-efficiency of actively managed mutual funds. The AMVR only requires the basic math skills of multiplication, division, addition and subtraction (My Dear Aunt Sally) and requires minimum data inputs, all of which are available for free online.

In conducting a fiduciary prudence audit, InvestSense uses both the AMVR and another proprietary metric, the InvestSense Quotient (IQ). While the AMVR focuses purely on cost-efficiency, the IQ analyzes an actively managed fund on a more qualitative basis, evaluating a fund on efficiency, both in terms of cost and risk management, and consistency of performance.

The AMVR worksheet below shows the results of a forensic analysis between one the ten most commonly used active funds in U.S. 401(k) plan’s and a comparable index fund. Since the active fund’s incremental costs are larger than the  fund’s incremental returns, the fund would be characterized as an imprudent fiduciary investment under the Restatement’s prudence guidelines.

The AER column refers to the correlation-adjusted costs for the active funds. As mentioned earlier, the high correlation of returns between many actively managed funds and comparable index funds not only raises the issue of closet indexing and misrepresentation as to the amount of active management provided by a fund, but it also raises the effective costs an investor has to pay. As the graphic shows, the effective cost increases dramatically as the correlation of returns between the funds increases.

At the end of a fiduciary prudence audit, we provide the client with a “cheat sheet” that they can use to calculate the AMVR for themselves. We provide two sets of numbers, One set of numbers is based on the nominal, or publicly stated, annual expense and return numbers. These are the numbers commonly cited by most mutual funds and plan advisers. The second set of numbers are the risk-adjusted return and correlation-adjusted costs numbers. We provide these adjusted numbers so that a plan can see what the plaintiff attorneys often use to evaluate a plan and the potential damages claim. For more information about the AMVR and the calculation process required, click here.

Over the years, the AMVR and the IQ have produced the same findings, namely that the overwhelming majority of actively managed funds are not cost-efficient. As the following graphic shows, the cost-inefficiency becomes even more pronounced in retail funds that charge a front-end load, a commission, just to purchase one of their funds.

The final component of BRIC is correlation of returns. As previously mentioned, actively managed funds that have a high correlation of returns with a comparable index fund raises questions regarding the actual amount of active management received by an investor and the effective costs of same.

The Active Expense Ratio (AER )is a metric often used to calculate the effective annual expense ratio that investor pay in such situtions. Ross Miller, creator of the  AER, described the reason that a fund’s publicly stated annual expense may be misleading:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs 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.(19)

Given the increasing trend of most U.S. domestic equity-based to show a high correlation to comparable index funds. Some have suggested that this trend is an attempt by actively  managed funds to reduce any significance variance in returns between active and index funds and the potential loss of investors in their funds.

Whatever the reason, the trend of increasing correlation of return numbers between domestic equity funds and comparable index funds is undeniable. As a result, a strong argument can be made that a failure of plan sponsors and other investment fiduciaries to calculate and consider such correlation- adjusted costs violates their fiduciary duty to make an independent, thorough, and objective investigation and evaluation of all of the investment options within a plan.

3. Legal rules regarding reliance on third-parties
ERISA allows 401(k) plans to seek advice from third-parties, even encourages the practice. However, both ERISA and the courts clearly impose conditions and restrictions on the use of such third-party advice.

First, a plan cannot blindly rely on third-party advice.

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard….The failure to make an independent investigation and evaluation of a particular plan investment is a breach of fiduciary duty. (20)

Our focus in on whether the fiduciary engaged in a reasoned decision-making process, consistent with that of a ‘prudent man acting in [a] like capacity.'(21)

In selecting third-parties, the courts have consistently held that plans must only use third-parties that are experienced, objective and otherwise qualified to provide such services. The objectiveness requirement is often used by the courts to rule that a plan’s reliance on a third-party was not justifiable due to inherent conflicts of interest issues of the third-party.

While ERISA attorneys are well aware of the Liss v. Smith decision, most plan sponsors are not. In that decision, the court held that a plan’s reliance on a  commission-based insurance agent was not justifiable, stating that

Blind reliance on a [broker] whose livelihood [is] derived from commissions he is able to garner is the anti-thesis of [a fiduciary’s duty to conduct an] independent investigation.(22)

As Fred Reish, one of America’s  most-respected ERISA attorneys, likes to say, “forewarned is forearmed.”

4. Available recourse for poor investment advice provided to a plan.
After I finish a fiduciary prudence audit, the two most common responses are concern over potential liability exposure and whether the company has any legal recourse against the party who provided the poor advice. I always review plan’s advisory as part of my audit, especially with regard to any attempted fiduciary disclaimer clauses. Such disclaimer clauses have become boilerplate in most plan advisor contracts, especially contracts involving large advisory firms and contracts where the advisor is either a broker-dealer, registered investment advisor, or insurance company.

What we are seeing is a new trend of plans suing plan advisor under such common law principles as negligence, fraud ad breach of contract. The argument in such cases is that the plan advisor knew that the client was an ERISA plan and that they paid for a certain level of advice, advice that would meet applicable legal standards. After all, the law generally requires that when one pays someone for a service, the payer is entitled to receive from the person paid services that are commensurate with or greater than the compensation paid.(23)

Plan advisors have generally tried to dismiss such legal actions by claiming that such civil actions are impermissible and that any such disputes are governed by ERISA. However, the courts have consistently ruled that such cases are no different than any other contract dispute and, generally speaking, may be properly bought in separate court action since they do not involve ERISA issues.(24)

Going Forward
I often hear CEOs and plan sponsors dismiss a possible 401(k) fiduciary breach action by saying they will simply claim that they did not know the law and that they did not intent to hurt anyone. If the reader takes nothing  away from this article but this, it will justify the time they invested.

A pure heart and an empty head are no defense [to claims of one’s fiduciary duties].”(25)

Anyone contemplating the use of such a strategy should remember the following warning provided by the court in the Fink decision:

The 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)(26)

As I explain to prospective clients and ERISA attorneys, the bottom line  is that the AMVR helps plan sponsors satisfy the “knew” aspect of the court’s warning, while at the same time providing ERISA attorneys with evidence regarding the “should have known” issue.

The concepts and calculations behind the AMVR are simple, sound and persuasive. In addition to an understanding of the power of the AMVR,  the three key takeaways that  plan sponsors and other investment fiduciaries will hopefully remember are:

  • Investment options within a 401(k) plan must be cost-efficient and evaluated individually for prudence.
  • Plans may seek advice from third-party parties. However, plan sponsors must conduct their own independent, objective and thorough investigation and evaluation of the investment options within their plan. Reliance on any advice from commission-based professionals is not legally justifiable and, thus, offers no protection to plans or plan sponsors.
  • Regardless of whether a plan’s third-party advisory contract attempts to disclaim any fiduciary liability for the advice that they provide to a 401(k) plan, a plan has the power to attempt to hold a third-party liable for poor advice under common law principles.

While the Brotherston decision technically only applies to the court within First Circuit’s jurisdiction, the soundness of the court’s logic and they fact they relied on basic fiduciary principles leads many to believe that other courts will adopt the First Circuit’s rationale. Again, “forewarned is forearmed.”

1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018).
2. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007
3. SEC Speech: The Future of Securities Regulation: Philadelphia, Pennsylvania: October 24, 2007 (Brian G. Cartwright).
4. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds,
5. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANE 179, 181 (2010)
6. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017,
7. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997)
9. Pfeil v. State Street Bank & Trust Co., 671 F.3d 585, 587, 597-598 (6th Cir. 2012).
10. Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009). (Hecker I)
11. Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009). (Hecker II)
12. DiFelice v. U.S. Airways, 497 F.3d 410, 420 (4th Cir. 2007).
13. RESTATEMENT (THIRD) TRUSTS, (American Law Institute),Section 90, cmt b.
14. RESTATEMENT (THIRD) TRUSTS, (American Law Institute), Section 90, cmt f.
15. RESTATEMENT (THIRD) TRUSTS, (American Law Institute), Section 90, cmt h(2).
16. Fink v. National Sav. & Trust Co., 772 F.2d 951, 957 (D.C.C. 1985).
17. Howard v. Shay, 100 F.3d 1484, 1488 (4th Cir. 1996).
18. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983).
19. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007)
20. Fink, supra.
21. DiFelice, supra.
22. Liss v. Smith, 991 F.Supp.2d 297, 300 (S.D.N.Y 1998); Gregg v. Transportation Workers of America Intern., 343 F.3d 833, 841 (6th Cir. 2003).
23. RESTATEMENT OF CONTRACTS, (American Law Institute), Section 205
24. Berlin City Ford, Inc. v. Roberts Planning Group, 864 F. Supp. 292 (D. New Hampshire 1994)
25. Cunningham, supra.
26. Fink, supra.

This article is for informational purposes only and is neither designed nor intended to provide legal, investment or other professional advice since such advice always requires consideration of individual facts and circumstances. If legal or other professional assistance is needed, the services of an attorney other appropriate professional adviser 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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