Winds of Change

I recently posted on both Twitter and LinkedIn my belief that plan participants should never lose a properly vetted 401(k)/403(b) fiduciary breach action. As expected, the posts drew a strong response.

I recently participated in a private conference to discuss my rationale and theories on the future of 401(k)/403(b) litigation. What was slated for an hour presentation turned into a two-hour plus presentation. I thoroughly enjoyed every minute of it. The participants echoed that sentiment.

We discussed some of my prior blog posts addressing the current state of 401(k)/403(b), including the courts’ misguided application of the “apples to oranges” and “menu of options” defenses commonly put forth by plans. Brotherston effectively nullified the “apples and oranges” defense by pointing out that the goal of ERISA is to use whatever products and strategies most effectively serve the plan participants’ goal of “retirement readiness.

The “menu of options” defense has never had any legal merit. ERISA Section 404(a) itself points out that ERISA requires that each investment option offered within a plan must be prudent both individually and in terms of the plan as a whole. Both the Hecker II decision and the DeFelice decision reiterated ERISA’s position.

Plans often reference the Hecker I decision in support of the “menu of options” defense. For some reason they never mention that the 7th Circuit quickly back and “clarified” their earlier decision. While the Court referenced their Hecker II decision as a “clarification,” many attorneys deemed it to be a reversal of their Hecker I decision, and rightfully so.

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.)(1)

And yet, the courts continue to dismiss 401(k) action, citing the “menu of options” defense.

SCOTUS recently announced that it was considering hearing the Northwestern University 403(b) decision. The Court needs to hear the case to ensure that courts are applying ERISA uniformly. The rights and guarantees provided by ERISA are far too important to be depend on questions of geography.

At the end of each calendar quarter I prepare an analysis of the non-index funds in the top ten mutual funds in “Pensions & Investments” top 100 mutual funds in defined contribution plans. The 3Q 2020 analysis is available here.

During the recent Zoom presentation, I offered some additional research that I typically provide to clients. John Langbein, the reporter for the committee that drafted the Restatement (Third) of Trusts, had expressed a 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 1st Circuit suggested the same thing in Brotherston, with the court suggesting that plans who had a problem with their decision might consider simply utilizing index funds. This statement upset many in the investment and pension industries, but an objective analysis of a key category of funds that 401(k)/403(b) plans commonly use, large cap funds, supports the 1st Circuit’s statement.

During the Zoom conference, I offered some additional research that I have provided to my consulting clients. Using the Morningstar Investment Research Center application, I created a screen for comparing large cap retirement funds-large cap blend, large cap growth and large cap value-to comparable Vanguard retirement funds.

The screen I created was as follows:

  • 5-year annualized return > benchmark
  • Expense ratio < benchmark
  • Standard deviation < benchmark

The screen was applied progressively, meaning that a fund was disqualified as soon as it failed to any of the screens.

The results were as follows:

Large Cap Blend (benchmark – Vanguard S&P 500 Index Admiral shares=VFIAX)
Funds in category – 1252
5-year annualized return >= benchmark – 99
Expense ratio <= benchmark – 8
Standard deviation <= benchmark – 6
Final results: Vanguard Large Cap Blend Fund Admiral shares, Fidelity 500 Index Fund, iShares S&P 500 Index K shares, and State Street Equity 500 index Fund. The other two Vanguard Institutional funds had extremely high minimums)

Large Cap Growth (benchmark – Vanguard S&P 500 Index Admiral shares=VFIAX)
Funds in category – 1282
5-year annualized return >= benchmark – 283
Expense ratio <= benchmark – 7
Standard deviation <= benchmark – 4
Final Results: Vanguard Growth Index Admiral shares, Fidelity Advisor Series Equity Growth Fund. and American Century NT Growth Fund G shares. The TIAA-CREF Institutional fund had an extremely high minimum)

Large Cap Value (benchmark – Vanguard S&P 500 Index Admiral shares=VFIAX)
Funds in category – 1103
5-year annualized return >= benchmark – 139
Expense ratio <= benchmark – 2
Standard deviation <= benchmark – 1
Final Results: Vanguard Value Index Fund Admiral shares

The end-results were the same for analyses using the 10-year annualized returns. Perhaps the 1st Circuit and John Langbein should not be so easily dismissed by plans and the investment industry.

As I told those on the call, IMHO decisions such as the Salesforce and CareerBuilder serve no real purpose other than providing plans with a false sense of security. Those decisions that are appealed are usually reversed, as the evidence just does not support the lower court’s decision and the lower court’s decision is often based on theories that have been rejected by appellate courts.

Going Forward
I know that there are many who will disagree with my research and conclusions. Again, that is why I hope SCOTUS grants cert to the Northwestern University case and creates one uniform standard for sufficiency of pleadings in ERISA actions. As those who follow me know, I support a standard which places the burden of proof regarding causation on plans since they are the party with the relevant specifics.

Earlier, before the Brotherston decision was announced, I suggested that the decision would be a pivotal point in the 401(k) arena. I now suggest that SCOTUS’ decision whether to hear the SalesForce decision and the decision it hands down may also be a pivotal point in further defining the 401(k)/403(b) arena, especially if the burden of proof as to causation is imposed on plans going forward. Both plans and the investment industry realize that they cannot carry such a burden of proof, as the evidence clearly shows that most actively managed funds are not cost-efficient, and do in fact cause the overwhelming losses within pension plans and accounts.

Referenced previous posts:

(1) Hecker v. Deere & Co., 569 F.3d 708 (7th Cir. 2009).
(2)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

(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.

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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