Less Is More: Plan Sponsors and the Art of Fiduciary Thinking

When I read about the House passing the SECURE 2.0 bill, I had three immediate thoughts:

  • “Annuities are sold, not bought.”
  • “So, plan sponsors are going to be able to automatically force employees to contribute to non-compliant 401(k) plans loaded with cost-inefficient, legally imprudent actively managed mutual funds.”
  • “It’s a fiduciary trap.”

It’s the third point I want to focus on in this post. SCOTUS recently addressed the impropriety of 401(k) plans combining prudent and imprudent investment options within a plan.

Now, plans are being advised to unilaterally insert defensive clauses into their plans in an effort to reduce 401(k) and 403(k) litigation. Given the fact that such clauses would obviously only benefit the plan, it would seem that such strategies would blatantly violate the plan sponsor’s fiduciary duty of loyalty, the duty to act exclusively in the best interests of the plan participants and their beneficiaries.

As for SECURE 2.0, forcing employees to contribute to a non-compliant ERISA plan raises obvious legal liability questions. As for allowing annuities, in any form, in 401(k) plans, the is indefensible, as will be discussed later.

As a former securities and RIA compliance director, I am well-acquainted with the financial services’ saying-“annuities are sold, not bought”–and the truth behind the saying and reasons for same. The annuities industry has continually attempted to get RIAs and 401(k) plans to embrace their products. Smart investment fiduciaries have refused to fall into the liability trap that annuities pose for fiduciaries.

Fiduciary law is a combination of three types of law–trust, agency and equity. The fundamental concept of fiduciary law is fundamental fairness.

SCOTUS has consistently recognized the fiduciary principles set out in the Restatement (Third) of Trusts (Restatement) as guidelines for fiduciary responsibility and prudence. The two consistent themes throughout the Restatement are cost-efficiency and risk management through diversification.

I am 67, so I remember the famous “Pogo” cartoon strip where Pogo says “we have met the enemy…and he is us!” In far too many instances, that sums up the current fiduciary liability crisis involving plan sponsors. I honestly believe that most plan sponsors have good intentions. The problem is that they continue to listen to the wrong parties and blindly rely on such parties’ advice, even though the courts have consistently stated that such blind reliance on third-party advice is a per se breach of their fiduciary duties.

It is by now black-letter ERISA law that ‘the most basic of ERISA’s investment fiduciary duties [is] the duty to conduct an independent investigation into the merits of a particular investment.’ The failure to make any independent investigation and evaluation of a potential plan investment’ has repeatedly been held to constitute a breach of fiduciary obligations. Liss v. Smith, 991, F. Supp. 278, 297 (S.D.N.Y. 1988)

So, this is not a new requirement that should come as a surprise to 401(k) plan sponsors. In my conversations with plan sponsors during audits and casual conversations, they obviously are aware of the requirement and the consequences for non-compliance. The problem–they consistently admit that they do not know how to perform the required investigation and evaluations.

Plan sponsors are saying that they have never been trained to think like a fiduciary. The obvious question is “why.” Why have plan advisers not taught them how to perform he required fiduciary procedures? Is it to prevent plan sponsors from being able to assess the true value, or lack thereof, of the services that their plan advisor provides? Is it a self-serving strategy by plan advisers to try to justify their high fees with unnecessarily complex and confusing plans?

Whatever the reason, why have plan sponsors not taken the initiative to find someone to teach them what the applicable law is, how to use that law to design a legally compliant decision-making process rather than constantly exposing themselves the unnecessary fiduciary liability/ Trust me, 401(k) litigation is only going to get worse.

I was a PoliSci major in college. However, my minor was psychology, with a concentration in cognitive psychology, the study of decision-making. The human mind continues to fascinate me.

Most people know Annie Duke as a champion poker player. What most people do not known is that Annie has an M.B.A. in cognitive psychology. She now practices as a decision strategist. She has written two excellent books on the decision-making process, “Thinking in Bets” and “How to Decide.” Her third book, “Quit,” comes out this Fall.

Annie’s message is simple and direct: the quality of our lives depends on the quality of our decisions and luck.  In “How We Decide,” Annie discusses the value of quit-to-itiveness, the value of realizing that change is needed and can be a positive move,

When I created the Active Management Value Ratio (AMVR) metric, part of the reasoning was to help teach investment fiduciaries how to avoid unnecessary fiduciary risk by thinking like a fiduciary, how to simplify the fiduciary prudence process. The other part of the reasoning, honestly, was to help fellow ERISA plaintiff attorneys expose ERISA non-compliant 401(k) and 403(b) plans.

I figured attorneys would listen to the rationale behind the metric. They have. I figured that plan sponsors, trustees and other investment fiduciaries would not listen. I was right.

With the Hughes v. Northwestern University decision and the resulting “fiduciary responsibility trinity” of Hughes, Tibble v. Edison International, and Brotherston v. Putnam Investments, LLC, plan sponsors and other investment fiduciaries are clearly at the crossroads, as it is time to “fish or cut bait.” Again, 401(k)/403(b) litigation is not going away. To be honest, the cases are simply too easy to win or settle as long as they are properly plead.

For example, if I were to present this AMVR forensic analysis to you as a plan advisor, what would you decide-prudent or imprudent?

Nobel laureate Dr. William Sharpe has offered the following advice for analyzing the prudence of mutual funds:

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.”

Noted wealth management expert, Charles D. Ellis, goes further, stating that

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!

So, analyzing the AMVR forensic analysis as a fiduciary using the following guidelines, would you deem the actively managed fund to be prudent or imprudent?

The actively managed fund is clearly an imprudent investment for a fiduciary, or anyone else for that matter, relative to the benchmark used, the Vanguard Large Cap Growth Index Fund (VIGAX). Yet the actively managed fund shown, Fidelity Contrafund Fund, K shares (FCNKX), is consistently in the top five funds in U.S. domestic 401(k) plans. Common sense should indicate that any fund whose incremental costs exceed their incremental return, when cost exceed benefits, is imprudent.

So, what about annuities. I wrote a lengthy post on the issue of variable annuities https://investsense.com/2021/04/21/variable-annuities-reading-between-the-marketing-lines/. The high costs associated with annuities and the potential loss of one’s life’s savings to the annuity issuer rather than one’s heirs are negatives often associated with annuities.

Annuities within 401(k) plans add yet another issue, the possibility that the 401(k) may be forced to annuitize an annuity in order to make the required minimum distributions required on retirement accounts. Once an annuity owner annuitizes the annuity, the annuity issuer, not the annuity owner, owns and controls the funds in the annuity. Some annuities are so determined to get their hands on the funds in an annuity that they force the annuity owner to annuitize at a certain age. 

As Annie would say, annuities are essentially a bet. The annuity company calculates your life expectancy and bases payments accordingly. The annuity is betting that you will die sooner than projected, resulting in a cash “windfall” for them. Same goes if the annuity owner chooses a life/survivor option, in which case the payments to the annuity owner and survivor are reduced to factor in the combined life expectancy. Again, the annuity issuer is betting that the owner and the survivor will die earlier than estimated, leaving a cash “windfall” in the annuity for the issuer, not any heirs.

Whenever I perform a 401(k) fiduciary audit, I talk to the plan sponsor and investment committee to determine just how well they understand their fiduciary duties. In most cases, not very well, if at all. As I mentioned earlier, in most cases they just blindly accept whatever their plan adviser of some other third-party tells them.

“Retirement readiness” is a buzzword often heard in connection with 401(k) and 403(b) plans. Plan sponsors and investment committees often tell me that means they need to ensure the performance of the investment options chosen for their plan. I then explain to them that they simply cannot ensure such results; that their only fiduciary duty is to perform the required independent investigation and evaluation and use a prudent process to select the fund’s investment options.

I always enjoy the reaction when I explain to a plan sponsor and an investment committee just how easy it is to design, implement and maintain an ERISA compliant 401(k)/403(b) plan. Rick Ferri, Chris Tobe and I recently established the “CommonSense 401(k) Project’ for the purpose of explaining just how simple and cost-efficient operating an ERISA compliant 401(k) plan can, and should, be.

Plan sponsors and investment committees are amazed when I explain that ERISA compliant 401(k) plans can be designed with as few as 3-5 prudently selected investment options. No more confusing 20-30 investment option plans, no more “paralysis by analysis.” This generally makes the required fiduciary duty of ongoing monitoring process easier, reduces costs, and potentially increases employee participation due to the simplicity of participating in the plan.

Going Forward
Assuming that SECURE 2.0 becomes law, 401(k) plan sponsors and investment committees face some significant decisions, decisions which could easily expose both the sponsor and investment committee to unnecessary fiduciary liability exposure. To avoid such situations, plan sponsors and investment committees need to learn and understand the applicable laws and learn how to think like investment fiduciaries. By doing so, they can create a win-win 401(k) plans, a situation where “less is more” is actually legally compliant. For further information and to schedule a free consultation, visit https://commonsense401kproject.com

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member 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 on sound, proven investment strategies that will help them protect their financial security.
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