This past Monday, SCOTUS issued its much anticipated decision in Hughes v. Northwestern University (#Northwestern403b) The original issue before the Court was whether or not the plan participants had properly plead their case in their complaint. The lower courts had dismissed the case, relying on a concept known as the “menu of options” defense.

The basic argument of the “menu of options” defense has been that plans satisfy their fiduciary duties under ERISA as long they offered a mixture of investment options, even if some of those investment options would be considered imprudent under applicable legal standards.

In a unanimous 8-0 vote, the Court rejected the “menu of options” defense. Justice Sotomayor, writing for the Court, cited the Court’s decision in Tibble v. Edison International¹, stating that

The Court of Appeals for the Seventh Circuit held that petitioners’ allegations fail as a matter of law, in part based on the court’s determination that petitioners; preferred type of low-cost investments were available as plan options. In the court’s view, this eliminated any concerns that other plan options were imprudent.

That reasoning was flawed. Such a categorical rule is inconsistent with the context-specific inquiry that ERISA requires and fails to take into account respondents’ duty to monitor all plan investments and remove any imprudent ones.¹

The court vacated the 7th Circuit’s decision and remanded the case back to that court for reconsideration of the plan participants’ allegations.

The implications of this decision cannot be overstated. The decision not only impacts the plan participants in this case, but obviously plan participants in other 401(k) and 403(b) plans. It can, and undoubtedly will be, argued that the Court’s decision is equally applicable to all investment fiduciaries, e.g., trustees, since in Tibble, the Court relied heavily on the Restatement (Third) of Trusts (Restatement) and recognized the Restatement as an authoritative reference source in fiduciary actions.

The key question going forward will obviously be how does an investment fiduciary determine the prudence of a plan investment option. Since Justice Sotomayor relied heavily on the Court’s Tibble decision, I will too.

The two constant themes throughout the Restatement are cost-efficiency and effective diversification. I would suggest that Section 90 of the Restatement, more commonly known as the “Prudent Investor Rule,:” provides four criteria that should always be considered in assessing the fiduciary prudence of any investment.

• The “Introductory Note” to Section 90 states that cost-consciousness is a fundamental duty in connection with prudent investing.²
• Comment f of Section 90 states that a fiduciary has a duty to seek the highest rate of return for a given level of costs and risk, or, alternatively, the lowest level of cost and risk for a given level of return.³
• Comment h(2) states that due to the higher costs and risk typically associated with actively managed products/strategies, a fiduciary should only recommend and/or utilize such funds/strategies when it can be objectively estimated that such funds/strategies will provide a commensurate level of return for such additional costs and risks. Comment h(2) is often referred to as the ,“commensurate return” rule.⁴
• Comments m authorizes the use of index funds for benchmarking purposes in evaluating the cost-efficiency/prudence of actively managed mutual funds.⁵

These four comments, collectively, provide a sound framework for creating a legally acceptable fiduciary prudence due diligence process.

The search for fiduciary prudent actively managed mutual funds will be a challenge. Academic research has consistently found that the overwhelming majority of actively managed funds are not cost-inefficient, with conclusions such as

• 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.⁶
• 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.⁷
• [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁸
• [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.⁹

Several years ago I created a simple metric, the Actively Managed Value Ratio 3.0™ (AMVR), based on the four previously discussed Restatement comments and the conclusions shown above. Using free publicly available information and basic math skills, fiduciaries, investors and attorneys can evaluate the cost-efficiency of an actively managed mutual fund.

The AMVR analysis shown below illustrates just how simple, yet powerful, the AMVR can be. The analysis is of a well-known actively managed fund that is annually cited as being among the top ten funds in U.S. defined contribution plans by “Pensions & Investments.”

The AMVR is essentially the familiar cost/benefit analysis taught in economics classes, with incremental costs and incremental returns being the input variable, incremental costs divided by incremental returns. An AMVR score greater than 1.00 indicates that the actively managed fund’s incremental costs exceed the fund’s incremental returns. Using a basic definition of prudence, i.e., benefits exceed costs, an AMVR score greater than 1.0 would indicate cost-inefficiency, and thus an imprudent investment relative to the benchmark index fund.

Using the example shown above, the obvious challenge for a plan sponsor, or any investment fiduciary, would be how to justify an additional incremental cost of 72 basis points for only an additional incremental return of 5 basis points as a prudent investment decision. It simply is not.

Going Forward
In a recent article, Jaime A. Santos and Christina Hennecken of Goodwin Proctor, LLP, wrote that

Moreover, the Court’s nod to the range of reasonable judgments fiduciaries may make underscores what many plan sponsors and industry groups have consistently argued in defending ERISA suits—there is no one-size-fits-all approach to plan management and fiduciary decisions, which need to be evaluated based on the context in which they were made. Although this decision is unlikely to slow the onslaught of new lawsuits plan sponsors have faced in recent years, it confirms the appropriate pleading standard that should be used to examine these lawsuits and directs courts to consider the range of reasonable judgments a fiduciary may make.¹⁰

“Range of reasonable judgements a fiduciary may make” is a phrase that I expect will be commonly referenced in 401(k) litigation going forward. However, as noted in the Tibble decision,

We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ In determining the contours of an ERISA fiduciary’s duty, court often must look to the law of trusts.¹¹

As courts have consistently noted, ERISA is essentially the codification of the Restatement of Trusts, which is simply a restatement of the common law of trusts. That said, based on the evidence set out herein, I would respectfully suggest that there is a one-size-fits-all approach to plan management and fiduciary decisions – cost-efficiency and the “commensurate return” guidelines of Section 90, comment h(2), of the Restatement (Third) of Trusts. Both the law and common sense support such a position.

In counseling plan advisors and investment fiduciaries in general, I find myself coming back to three quotes that set out simple and sound guidelines for making fiduciary decisions.

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!¹²

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 occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”¹³

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.¹⁴

Perhaps the answer is some form of a simple, common sense 401(k) model that truly promotes the best interests of plan participants best interests, while also reducing a plan sponsor’s potential fiduciary liability exposure. Just a thought.

Selah.

Notes
1. Hughes v. Northwestern University, https://www.supremecourt.gov/opinions/21pdf/19-1401_m6io.pdf
2. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
3.. 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.
4. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
5. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
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. https://www.jdsupra.com/legalnews/hughes-et-al-v-northwestern-university-2052029/
11. Tibble v. Edison International, 135 S. Ct. 1823 (2015). https://www.supremecourt.gov/opinions/14pdf/13-550_97be.pdf.
12. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
13. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
14. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law(1976). (Faculty Scholarship Series: Paper 498) available online at http://digitalcommons.law.yale.edu/fss_papers/498.

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