After reading the court’s opinion dismissing the Intel 401(k) action, two things immediately came to mind: (1) the brilliance of the First Circuit’s Brotherston decision, and (2) how increasingly some of the dismissals of 401(k) actions seem to be more focused on improperly preventing the plan participants from having discovery and the opportunity to discover the truth about the plans actions.

The second point may seem harsh at first, but the Brotherston decision essentially made the same suggestion. And if we examine the rationales commonly expressed by some of the courts in dismissing 401(k) breach of fiduciary duties actions, I believe there is strong evidence to support my suggestion.

ERISA’s Purpose Diverted
ERISA was enacted to provide employees with protection against employer abusive practices in connection with company pension plans. However, some of the recent arguments by the courts seemingly inequitably protect the employers at the expense of the employees.

For instance, one rationale cited by the court’s is the “apples and oranges” concept, the argument being that comparisons between actively managed mutual funds and passively managed index funds are inherently inequitable and inadmissible. The First Circuit quickly dismissed that argument, pointing out that with regards to ERISA, the primary focus should be on what is in the best financial interests of plan participants as they work toward “retirement readiness.”

In Tibble v. Edison International, Inc,² SCOTUS recognized the Restatement of Trusts (Restatement) as a resource often used by the courts in resolving fiduciary questions. Section 90 of the Restatement, more commonly known as the Prudent Investor Rule, cites three particularly pertinent.

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;³
• 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;⁴ 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.⁵

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.”⁶
• “[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.”⁷
• “[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.”⁸
• “[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”⁹

I would also suggest that a simple cost-efficiency analysis using InvestSense’s proprietary metric, the Active Management Value Ratio^TM (AMVR), would expose a major shortcoming of the “apples/oranges” argument.

Below are the basic forensic AMVR analyses for two well known known mutual funds that are often selected by 401(k) plans-Fidelity Contrafund class K shares and American Fund’s Growth Fund of America class R-6 shares. In both analyses, Fidelity’s Large Cap Growth Index Fund is used for benchmarking purposes.

Interpreting the AMVR is equally easy. 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 fund provide 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.

While these simple analyses make the point that comparing two cost-inefficient actively managed mutual funds in no way benefits or protects plan participants, a strong argument could be made that doing so, that not including a cost-efficiency analysis using a comparable index funds, would violate a plan sponsor’s duties of loyalty and prudence.

When we prepare AMVR analyses for plans, attorneys, and trusts and other fiduciary entities, we provide a more in-depth analyses using risk-adjusted returns and correlation-adjusted costs. Such advanced analyses often illustrate just how egregious the cost-inefficiency of an actively managed fund, and the breach of fiduciary duties, can be. For further discussion of the “apples/oranges argument can be found on this site at Winds of Change | The Prudent Investment Fiduciary Rules (wordpress.com) and The CareerBuilder 401(k) Decision: Three Key Lessons for Plan Sponsors and ERISA Attorneys | The Prudent Investment Fiduciary Rules (wordpress.com)

These two articles and others on this site also address another rationale often cited by courts in dismissing 401(k) fiduciary breach actions, the “menu of options” argument. The argument is basically that a plan can insulate itself from fiduciary liability by just offering a large number of investment options within the plan.

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 decision¹⁰ and the DeFelice decision¹¹ reiterated ERISA’s position.

Plans often reference the Hecker I decision¹² 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.)¹³

And yet, the courts continue to argue the “menu of options” defense in dismissing 401(k) actions..

The “Meaningful Benchmark” Argument
The “meaningful benchmark” argument is increasingly being cited by courts in dismissing 401(k) actions alleging a plan sponsor’s breach of their fiduciary duties. In most cases, courts asserting this rationale cite Judge Doty’s decision in Meiners v. Wells Fargo Co.¹⁴ (Meiners).

The Meiners action involved the common issues of the underperformance and the excessive fees of the plan’s investment options. In addressing the underperformance issue, Judge Doty notes that the fund in question had a larger allocation to bonds than the fund used by the plaintiff in benchmarking. Therefore, Judge Doty said that relative underperformance was understandable, adding that

In order to plausibly allege a fund is underperforming, Meiners must provide some benchmark against which the Wells Fargo funds can meaningfully be compared.=¹⁵

In addressing the use of funds as comparators in general, Judge Doty stated that

[A] comparison of the returns of two funds is insufficient because ‘funds…designed for different purposes…choose their investments differently, so there is no reason to expect them to make similar returns over any given span of time.¹⁶

Judge Doty concluded by citing the 8th Circuit’s Tussey v. ABB, Inc. decision¹⁷ for the proposition that

Making [a] comparison [between two funds] would…imply a (mistaken view that whichever fund earned more over the relevant time frame ‘should’ have been offered to the participants, or even that it performed ‘better’ in a meaningful sense.¹⁸

Hold onto that thought.

On the subject of fees, Judge Doty stated that just as with the issue of performance, Meiners failed to provide a “meaningful benchmark” against which the Wells Fargo funds’ fees could be compared. Judge Doty made the familiar argument about plan sponsors not being obligated to select the cheapest investment option. Judge Doty concluded by stating that

Meiners must plead something more to make his excessive fees claim plausible….Nothing in the complaint suggests that the Vanguard and Fidelity funds are reliable comparators….Without a meaningful comparison, the mere fact that the Wells Fargo funds are more expensive than the other two funds does not give rise to a plausible breach of fiduciary duty.¹⁹

A Common Sense and Cost-Efficiency Solution
Of note, in neither Meiners nor any of the other 401(k) actions that have been dismissed upon reliance on the “meaningful benchmark” theory, have I seen an explanation or example of what would constitute an acceptable “meaningful benchmark.” I immediately thought of the First Circuit’s discussion about the inequity of forcing plan participants to try to read a plan sponsor’s mind, only to get a series of “nopes” and mind games.

We already have an unacceptable and inequitable situation where plan participants’ rights and protections under ERISA are being determined on where they live, not on the stated purpose and principles of ERISA. With the goal of fundamental fairness, equity and a purposeful advancement of participants’ goal of “retirement readiness,” I suggest that SCOTUS and the Restatement (Third) of Trusts have already provided a viable blueprint for making ERISA meaningful again.

In analyzing an investment option, Nobel laureate William F. Sharpe has stated that

‘[T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’¹²⁰

Building on Sharpe’s theory, investment icon Charles D. Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns.²¹

Ellis’ argument on behalf of forensic cost-efficiency analyses is consistent with SCOTUS’ endorsement of the Restatement of Trusts as a resource in resolving fiduciary issues. As mentioned earlier, the Section 90 of the Restatement stresses the importance of a fiduciary being cost-conscious.

The Restatement even sets out three core principles regarding the prudent evaluation and selection of actively managed mutual funds. One of the core principles is that an actively managed fund is an imprudent investment choice unless it can be objectively determined that the fund will provide a commensurate return for the additional costs and risks generally associated with actively managed funds. As mentioned earlier, the evidence overwhelmingly indicates that most actively managed funds do not even come close to meeting this hurdle.

Going Forward
Remember Judge Doty’s statements that

In order to plausibly allege a fund is underperforming, Meiners must provide some benchmark against which the Wells Fargo funds can meaningfully be compared.

[We need to avoid] a (mistaken view that whichever fund earned more over the relevant time frame ‘should’ have been offered to the participants, or even that it performed ‘better’ in a meaningful sense.

As outlined in this post, I believe analyzing actively managed funds based on a simple, cost-efficiency basis provides the objective and “meaningful” benchmarking Judge Doty was advocating and other courts are adopting . The AMVR metric allows investment fiduciaries such as plan sponsors and trustees, as well as litigators, to easily perform such an analysis, as the AMVR only requires the ability to perform what one judge described as “simple, third grade math.”

Neither cost-efficiency based benchmarking should not draw valid opposition in court. Cost-efficiency as a meaningful benchmark has been explicitly endorsed by the Restatement (Third) of Trusts and implicitly by SCOTUS, which recognized the Restatement as a viable resource in resolving fiduciary responsibility questions.

The use of the AMVR metric to perform cost-efficiency analyses in ERISA actions should also not encounter any serious opposition in litigation. The AMVR is simply a modified version of the widely accepted cost/benefit equation, using a fund’s incremental costs and incremental returns as the input data. Common sense tells us that when an investment’s incremental costs exceed its incremental returns, the investment is not prudent.

The rights and protections guaranteed to American workers are too important to depend on where a worker resides, the questionable misinterpretation of ERISA or various individual court interpretations of what constitutes a “meaningful” benchmark. Brotherston provided a meaningful and well-reasoned analysis of the current situation and a common sense solution to the problem by placing the burden of proof as to causation on plan sponsors since, in most cases, they alone have the relevant evidence on such issues.

SCOTUS is currently considering hearing the Northwestern University 403(b) case. The Northwestern case involves many of the issues discussed herein. SCOTUS desperately need to hear the Northwestern case to ensure that ERISA remains meaningful and American workers are protected against the abusive practices that are being exposed in the current 401(k)/403(b) fiduciary breach actions, decisions and settlements.

In my closing statement to the jury, I always asked the jury to do justice, citing the following quote by the late General Norman Schwarzkopf:

The truth is, we always know the right thing to do. The hard part is doing it.

SCOTUS, American workers desperately need a hero.

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018).
2. Tibble v. Edison, Intl. 135 S. Ct. 1823 (2015)
3. Restatement (Third) Trusts, Section 90, cmt. b. (American Law Institute)
4. Restatement (Third) Trusts, Section 90, cmt. f .(American Law institute)
5. Restatement (Third) Trusts, Section 90, cmt. h(2). (American Law Institute)
6. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
7. 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.
8. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
9. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
10. Hecker v. Deere & Co. (Hecker II), 569 F.3d 708, 711 (7th Cir. 2009).
11. DiFelice v. U.S. Airways, 497 F.3d 410, 423 fn. 8 (4th Cir. 2007).
12. Hecker v. Deere & Co. (Hecker I), 556 F.3d 575 (7th Cir. 2009).
13. Hecker II, supra.
14. Meiners v. Wells Fargo & Company, United States District Court (D. Minnesota), Civil No. 16-3981.
15. Ibid.
16. Ibid.
17. Tussey v. ABB, Inc., 138 S. Ct. 281 (2017).
18. Ibid.
19. Meiners, supra
20. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
21. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”               available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c

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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.