CommonSense 401(k) Prudence and Risk Management

Whenever I perform a forensic fiduciary advice on a 401(k) or 403(b) plan, I invariably find myself asking the plan sponsor and/or the plan’s investment committee the same two questions:

  1. Why do you have so many investment options?
  2. Why did you choose these specific investment options?

I typically one or some combination of the following three responses:

  1. “We were told that it was important to provide plan participants with ‘choices’.”

Providing plan participants with meaningful investment options is very important. However, most 401(k)/403(b) plans are dominated by actively managed mutual funds. Studies have consistently shown that the overwhelming majority of actively managed mutual funds are not cost-efficient and, therefore, are legally imprudent for pension plans. A cost-inefficient, legally imprudent investment options is not a “choice” for plan participants. It is fiduciary liability exposure for a plan and its fiduciaries.

2. “We were told that we could reduce our risk of being sued by offering a large number of investment options.”

Ah yes, the infamous “menu of options” argument. That argument was officially discredited by the Supreme Court’s recent Hughes v. Northwestern University decision. The Court, citing ERISA itself, ruled that each individual investment option within a 401(k) plan must be legally prudent. So the “menu of options” never had any legal legitimacy since ERISA provides otherwise. Nevertheless, many 401(k) plan that relied such faulty advice are now finding themselves in a difficult legal situation.

3. “We thought the more investment options we offered, the greater the odds of successful investing.”

Again, cost-inefficient investment options are not a legitimate investment “choice,” as their incremental costs exceed their incremental returns when evaluated against a comparable index fund. This answer also illustrates a lack of understanding as to what a plan sponsor’s fiduciary duties requires.

A plan sponsor is not required to guarantee the ultimate performance of the investment options chosen for a plan. Nobody can do that. Plan sponsors are only required to select legally prudent investment options for the plan participants by using a sound due diligence process.

Where many plan sponsors create unnecessary liability exposure for themselves is in following the advice of plan advisers and other third parties. While ERISA does allow, even recommend, that plans hire experts to help them if they lack the knowledge or experience to select prudent investment options for the plan, ERISA and the courts have consistently pointed out that (1) any reliance on such third-parties must be reasonable, and (2) the plan sponsor cannot blindly rely on advice from such third-parties, the plan sponsor must still perform a personal investigation and evaluation of all prospective investment options.

So, what constitutes “reasonable reliance?” The courts have ruled that reliance on third-parties that may be biased or otherwise influenced by potential or actual conflicts of interest is not considered reasonable.

  • “Over and above its duty to make prudent investments, the fiduciary has a duty to conduct an independent investigation of the merits of a particular investment….A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.” Fink v. National Saving & Loan, 772 F.2d 951 (D.C. Cir. 1985): Donovan v. Cunningham, 716 F.2d 1455, 1467; Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981)
  • “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, 991F.Supp. 278 (S.D.N.Y. 1998)
  • “While a plan sponsor may hire an adviser or other expert, [t]he fiduciary must (1) ‘investigate the expert’s qualifications’;  (2) ‘provide the expert with complete and accurate information’;  and (3) ‘make certain that reliance on the expert’s advice is reasonably justified under the circumstances.’”

“A determination whether a fiduciary’s reliance on an expert advisor is justified is informed by many factors, including the expert’s reputation and experience, the extensiveness and thoroughness of the expert’s investigation, whether the expert’s opinion is supported by relevant material, and whether the expert’s methods and assumptions are appropriate to the decision at hand. One extremely important factor is whether the expert advisor truly offers independent and impartial advice.” (emphasis added)

“Defendants relied on FPA, however, and FPA served as a broker, not an impartial analyst. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best.   A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative.   FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of “can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce. ” Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003)

  • “In determining compliance with ERISA’s prudent man standard, courts objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions.”

    “[F]iduciaries in other circumstances, are entitled to rely on the advice they obtain from independent experts. Those fiduciaries may not, however, rely blindly on that advice.” Bussian v. RJR Nabisco, Inc., 223 F.3d 286, 298-300 (5th Cir. 2000)

When I inform plan sponsors of these legal standards, they often respond by saying that it was their inability to perform such investigations and evaluations that led them to seek third-party advice. And that is obviously a valid point. In fact, that is one of the primary reasons why Rick Ferri, Chris Tobe and I co-founded the “CommonSense 401(k) Project,” (Project) to provide a resource that plan sponsors could turn to for experienced, (almost 100 years of combined experience) and objective advice.

The good news for plan sponsors and plan investment committees is that designing, implementing and maintaining a win-win 401(k) or 403(b) plan, one that truly provides both effective investment “choices” for plan participants and protects a plan’s sponsor and investment committee is actually quite simple and cost-effective.

After we talk to a plan about the Project’s concepts, the usual response is “why didn’t our plan adviser simplify the process like this?” While I have my theories, my advice is usually to ask them.

Many plans have asked me whether plan advisers should be required to support their investment recommendations with an Active Management Value RatioTM (AMVR) forensic analysis. Obviously, I am biased, since I created the metric. Then again, if the goal is to provide a plan and it participants with the best service and advice…why not? Even more important, plan sponsors and the plan’s investment committee should learn the AMVR methodology so they can perform the legally required investigation and evaluation.

For more information about the #CommonSense401kProject, visit our site at http://commonsense401kproject.

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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