The “Fiduciary Prudence Trinity”: A Blueprint for Evaluating the Prudence of Fiduciary Investments

In my last post, I discussed the significance of three ERISA related decisions-Tibble, Hughes/Northwestern and Brotherston. I like to refer to these three cases as the “fiduciary responsibility trinity,” because I believe that, collectively, they will shape the future of 401(k)/403(b) litigation by providing a “blueprint” for both plan sponsors and ERISA attorneys.

The “fiduciary responsibility trinity” provides a macro blueprint for 401(k)/403(b) litigation. The “fiduciary prudence trinity” provides the micro blueprint for 401(k)/403(b) litigation, a means of evaluating the prudence of a plan’s actual investment options.

The cornerstone of my fiduciary compliance consulting practice is InvestSense’s proprietary metric, the Active Management Value Ratio (AMVR). The AMVR evaluates the cost-efficiency of actively managed mutual funds relative to comparable index funds. While many actively managed funds compare their performance to a comparable market index, market indices do not allow for cost-efficiency analyses since indices do not have costs. That is why the AMVR uses comparable index funds, as such funds do have costs similar to actively managed mutual funds.

In Tibble, SCOTUS recognized the Restatement (Third) of Trusts (Restatement) as a valuable resource in addressing fiduciary issues. The fiduciary prudence trinity is based on three key provisions of section 90 of the Restatement, otherwise known as the “Prudent Investor Rule.”

The common law of trusts ‘offers a starting point for analysis of ERISA….’ 1

[R]ather than explicitly enumerating all of the powers and duties of trustees and other fiduciaries, Congress invoked the common law of trusts to define the general scope of their authority and responsibility.”2

Thus, a federal common law based on the traditional common law of has developed and is applied to define the powers and duties of ERISA plan fiduciaries….3

The Prudent Investor Rule contains three comments that could, and should, define prudence in future ERISA excessive fees/breach of fiduciary duty actions.

  • A fiduciary has a duty to be cost-conscious. (Introductory Section to Section 90)
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return. (cmt. f)
  • Actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent. (cmt. h(2).

The AMVR provides a quick and simple means of addressing each of the three points. Fidelity Contrafund and American Funds’ Growth Fund of America are two popular investment options in U.S. defined contributions plans. Based on the AMVR analyses shown below, should plan sponsors reconsider the inclusion of the funds?

In analyzing the results of an AMVR forensic analysis, the two primary questions are:

1. Does the actively managed fund provide a positive incremental return?
2. If so. does the positive incremental return exceed the actively managed fund’s incremental costs?

If the answer to either of the two questions is “no,” then the actively managed fund is imprudent compared to the benchmark index fund. It’s just that simple. Simple subtraction and division.

In the analyses shown above, both Fidelity Contrafund and Fund of America would be deemed imprudent since neither fund produced a positive incremental return relative to the benchmark fund. A plan sponsor, at a minimum, should consider placing such funds on a “watch” list and continue to monitor the funds.

InvestSense bases its analyses on quarterly returns. Obviously, such returns and analyses results are subject to change. The analyses shown above are based on the 5-year returns of each fund, for the period ending December 31, 2021. When InvestSense does a forensic analysis, we provide an analysis for both the most recent 5 and 10-year period in order to assess consistency of performance.

While it was unnecessary in this case to consider the correlation-adjusted incremental costs of either fund, it should be noted that both funds had an r-squared score of 98. Such costs are shown under the AER column, reflecting InvestSense’s use of Ross Miller’s Active Expense Ratio metric. Obviously, had the funds’ AMVR analyses been based on their AER numbers, their level of imprudence would have been even worse.

Going Forward
The 401(k)/403(b) industry has been changed forever, especially with regard to litigation. While ERISA plaintiff attorneys must still make sure their pleadings meet SCOTUS’ plausibility standard, their job has been made seemingly easier with both the Hughes/Northwestern decision and the resulting “fiduciary responsibility trinity.” By following the “blueprint” provided by combining the “fiduciary responsibility trinity” with the “fiduciary prudence trinity,” ERISA attorneys and plan sponsors/plan fiduciaries can properly protect their respective interests.

1. In re Enron Corp. Securities, Derivatives, and “ERISA” Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003) (Enron).
2. Ibid.
3. Ibid.

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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 circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor 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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