“If we desire respect for the law we must first make the law respectful.”
Supreme Court Justice Louis Brandies
Currently, we have different federal courts handing down various interpretations of ERISA. As a result, in some cases the public’s guaranteed rights and protections under ERISA are dependent on where the plan participants reside. This is neither equitable nor just.
These inconsistent interpretations and rulings are unnecessarily exposing plan sponsors to potential liability exposure. The purpose of this post is to alert plan sponsors, as well as attorneys, to these “traps” to ensure that plan participants are properly protected.
However, as I read the recent ruling by a 7th Circuit court in the CareerBuilder, LLC (“CareerBuilder”) 401(k) case.(1) I noticed that the court was arguing two common defense tactics, both of which have been soundly rejected, one by the 7th Circuit Court of Appeals itself. Technically, the court dismissed the plan participants’ action, for allegedly improper pleadings. To its credit, the court dismissed the action “without prejudice,” thereby allowing the plan participants to file amended leadings.
The court essentially ruled that the plan participants did not provide the plan with sufficient information to understand the nature of the plan participants’ claims. As a plaintiff’s attorney, I immediately thought of the 1st Circuit’s Brotherston decision(2) and the fact that the CareerBuilder court’s decision might have been different had the court followed the 1st Circuit’s position and shifted the burden of proof as to causation to the plan.
However, the court went on to discuss two commonly used defenses, (1) the “apples to oranges” comparison argument; (2) the “menu of funds” defense, neither of which have any merit with regard to 401(k) actions. The other thing that struck me was the availability of a perfect strategy to comply to the court’s request for more “detailed and specific” information regarding the plan sponsor’s deficiency in overall performance-the cost-inefficiency of actively managed mutual funds within a 401(k) plan.
The “Apples-to Oranges” Comparison Issue
In discussing the plan participants’ breach of fiduciary claims as to the plan’s responsibility to prudently select, monitor, and replace the investment options within a plan, the CareerBuilder court mentioned the same “apples to oranges” argument that Judge Young had announced in the lower court’s Brotherston decision.
As the 1st Circuit pointed out in reversing Judge Young’s decision, the “apples to oranges” argument simply has no merit in ERISA 401(k) actions, as the only question that matters is what best serves the plan participants’ goal of building their retirement plan accounts to achieve “retirement readiness. Not only did the 1st Circuit approve the use of Vanguard for benchmarking purposes, the court went on to suggest that if plan sponsors have a problem with the court’s ruling, the expeditious solution might be to only offer cost-efficient index funds in their plans.
While the CareerBuilder court did not ultimately base their decision on the “apples to oranges” argument, I found it puzzling why the court would even mention the theory after the 1st Circuit had completely discredited the argument in connection with ERISA 401(k)actions.
The “Menu of Funds” Defense
The CareerBuilder court cited the Hecker I decision several times for the proposition that plans and plan sponsors are insulated from liability as long as the plan offers “a comprehensive-enough menu of options,” “a ‘mix’ of alternatives,” and “an acceptable mix of options.” The court’s suggestion as to the viability of the “menu of options,” defense is not only inconsistent with ERISA itself, but totally inconsistent with the 7th Circuit’s statements in its Hecker II decision..
Fred Reish, one of the nation’s preeminent ERISA attorneys, wrote an excellent article addressing the question of whether 401(k) fiduciary prudence is determined by the prudence of each individual fund offered by a plan, or rather by the overall menu of funds offered.
The obligation of fiduciaries under ERISA is to prudently select, monitor, and remove individual investments, as well as to consider the performance of the portfolio as a whole. It is not an ‘either-or’ scenario; both requirements must be satisfied.(3)
Reish supported his position by pointing to the actual wording within the preamble to Section 404(a), which states that
[t]he regulation , however, is not intended to suggest either that any relevant or material attributes of a contemplated investment may be properly ignored or disregarded, or that a particular plan investment should be deemed to be prudent solely by reason of the propriety of the aggregate risk/return characteristics of the plan’s portfolio. (4)
The CareerBuilder court repeatedly cites the 7th Circuit’s initial Hecker v. Deere decision, aka Hecker I, in support of the “menu of funds” argument.(5) The reaction was so strong against the 7th Circuit’s suggestion as to the protection offered by the “menu of funds” defense that that the court quickly offered a “clarification” of its ruling in Hecker I, stating that
The Secretary[of Labor] also fears that our opinion could be read as a sweeping statement that any Plan can insulate itself from liability by the simple expedient of including a vey large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It would also place an unreasonable burden on unsophisticated plan participants who do not have the resources to prescreen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such “obvious, even reckless, imprudence in the selection of investments (as the Secretary puts in her brief.)(6)
So the 7th Circuit unequivocally denounced the “menu of funds” defense in Hecker II. And yet, the CareerBuilder court never referenced Hecker II in its discussion of the “menu of funds” defense. One could argue that the omission certainly raises a number of questions. However, once again, to be fair, the CareerBuilder court did not ultimately base its decision on the “menu of funds” argument.
The CareerBuilder court did base it decision to dismiss the plan participants’ case on their alleged failure to provide sufficient information to the plan to allow the plan to understand the nature of the participants’ claims. Once again, this would presumably not be an issue if the 7th Circuit followed the 1st Circuit’s position on shifting the burden of proof to the plan.
Be that as it may, the reality is that the 7th Circuit has not adopted the 1st Circuit’s Brotherston positions. So, both plan sponsors and ERISA plaintiff’s attorneys should heed the pleading policy statements provided by the CareerBuilder court.
In citing ERISA 401(k) cases that had survived a motion to dismiss, the CareerBuilder court noted that “the plaintiffs had included “numerous and specific factual allegations,” and “offered specific comparisons between returns on Plan investments and readily available alternatives,…” The court went to add that such information
permitted the inference of imprudence-[that] it was plausible that the [Plan] had a flawed process given that it, anomalously among its peers, retained clunker funds notwithstanding the availability of cheaper and higher performing alternatives.(7)
“Cheaper and higher performing alternatives,” in other words, more cost-efficient alternatives.
In my opinion, that is a key takeaway from the CareerBuilder decision for both plan sponsors and ERISA plaintiff’s attorneys. Plan sponsors that focus on cost-efficiency can ensure that their process is consistent with the prudence standards established by the Restatement (Third) of Trusts (Restatement), which SCOTUS recognized as a resource that the courts often turn to in resolving fiduciary questions.
As SCOTUS pointed out in their Tibble decision, ERISA is essentially the codification of the common law of trusts. The Restatement is simply that, a restatement of the common law of trusts. Section 90 of the Restatement, more commonly known as the Prudent Investor Rule, sets out three core obligations for fiduciaries:
- A duty to be cost-conscious;(8)
- 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; (9) and
- A duty to avoid the use or recommendation of actively managed mutual funds unless it can be objectively estimated that the actively managed fund will provide a level of return that is at least commensurate with the extra costs and risk associated with the actively managed fund.(10)
Hint: Academic studies have consistently shown that very few actively managed funds meet the last requirement. The studies have consistently shown that the overwhelming majority of actively managed funds are not cost-efficient, with conclusions such as
- “99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”(11)
- “[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.”(12)
- “[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.”(13)
- “[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”(14)
ERISA plaintiff’s counsel should keep a copy of these studies in their trial notebook to support their arguments in favor of cost-efficiency as a determining factor in opposing any motions to dismiss
The final piece of the puzzle is calculating the cost-efficiency, or cost-inefficiency, of the actively managed funds within a 401(k) plan. Fortunately, there is a simple, yet powerful, metric that I created, the Active Management Value Ratio (AMVR), which simplifies the cost-efficiency calculation process. After a little practice, most people have told me that they can perform an AMVR calculation on a fund in less than one minute. For more information about the AMVR and the calculation process, click here and here.
The AMVR simplifies the cost-efficiency evaluation process. Once an actively managed fund’s cost efficiency has been calculated relative to a comparable benchmark, usually a comparable index fund, the plan sponsor or the ERISA attorney only have to answer two simple questions:
1. Did the actively managed funds provided a positive incremental return?
2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs
If the answer to either of these of these questions is “no,” the actively managed is not cost-efficient and , therefore, does not meet the plan sponsor’s fiduciary duty of prudence.
Bottom line: Calculating the AMVR numbers for actively managed funds within a 401(k) plan allows a plan sponsor to demonstrate the prudence of their selection and monitoring process. The AMVR numbers attorneys with the details that some courts continue to require in order to defeat a motion to dismiss.
AMVR cost-efficiency numbers provide information regarding a fund’s underperformance and costs, and the extent of the resulting damages, thereby creating “genuine issues of fact” for litigators. As all litigators know, courts can only determine issues of law. Questions of fact are the sole province of the jury
Cost-efficiency is the financial services industry’s kryptonite. It is the reason they so vigorously oppose any mention of a true fiduciary standard for the industry. They have no defense against such evidence, as they know that the overwhelming majority of their investment products, and thus, their advice regarding same, is not cost-efficient and could never meet the “best interest” demands of a true fiduciary standard.
As I stated at the outset, SCOTUS needs to determine the issues addressed herein, especially the rule as to the burden of proof regarding causation, so that ERISA is uniformly applied in all courts. The rights and protections guaranteed to workers under ERISA are simply too important to be determined by where they reside.
1. Martin v. CareerBuilder, LLC, Case No. 19-cv-6463 (N.D. Ill 2020).
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018.
3. Fred Reish, “Removal Spot: The Duty to Remove Investments,” https://www.faegredrinker.com/en/insights/publications/2009/12/removal-spot-the-duty-to-remove-investments.
4. ERISA 404(a) (Preamble)
5. Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009)
6. Hecker v. Deere & Co., 569 F.3d 708 (7th Cir. 2009).
7. CareerBuilder, Ibid.
8. Restatement (Third) Trusts, Section 90, cmt. b. (American Law Institute)
9. Restatement (Third) Trusts, Section 90, cmt. f .(American Law institute)
10. Restatement (Third) Trusts, Section 90, cmt. h(2). (American Law Institute)
11. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
12. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8ez.
13. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P. (August 2016).
14. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997).
(c) Copyright 2020, The Watkins Law Firm. All rights reserved.
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.
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