Having read the CommonSpirit Health (CommonSpirit) decision1 and the related briefs several times, three key fiduciary risk management issues stand out to me with regard to plan sponsors
1. SCOTUS needs to expressly resolve this ongoing “apples and oranges” debate once and for all, to expressly rule on the propriety of using index funds for benchmarking purposes. I believe the Court may legitimately feel that they addressed and resolved the issue by refusing to grant certiorari in the Brotherston decision.2 The Sixth Circuit obviously feels differently, as it resurrected the “apples and oranges” argument in upholding the district court’s dismissal of the case.
In the CommonSpirit decision, neither the circuit court nor the Sixth Circuit acknowledged the First Circuit’s Brotherston decision and/or the court’s reliance on the Restatement (Third) of Trusts’3(Restatement) position on the propriety of using index funds for benchmarking purposes.
“So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100, cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes)”4
Neither court acknowledged SCOTUS’ denial of Putnam’s application for certiorari, which many would interpret as the court’s indication that both the First Circuit’s decision and underlying rationale were correct.
One circuit is not obligated to follow the decisions of another circuit, and laws are obviously open to differing opinions. However, the fact that neither court acknowledged Brotherston nor tried to distinguish the two cases is arguably noteworthy given the First Circuit’s reliance on the Restatement, a resource recognized by SCOTUS as a legitimate resource in resolving fiduciary questions in its Tibble decision.5
Hopefully, the Sixth Circuit’s decision will be appealed. The fact that the case involves the prudence of two competing products from the same mutual fund company makes the case even more appealing for review. As the Solicitor General’s amicus brief in Brotherston argued, the rights and protections guaranteed to employees by ERISA are too important to vary based upon in which jurisdiction employees may reside.
2. The whole “fiduciary disclaimer clause” issue needs to be addressed. More specifically, the question of whether a plan sponsor breaches his fiduciary duties of prudence and loyalty to the plan participants by agreeing to an advisory contract that contains a fiduciary disclaimer clause. Again, I think the CommonSpirit case brings this issue into focus since the case involved similar, yet competing, products offered by the plan adviser, Fidelity Investments.
I think several issues need to be explored and addressed with regard to the use of fiduciary disclaimer clauses in 401(k) plan advisory contracts. It can be argued that removing a plan adviser’s fiduciary obligations allows firms to argue that their advice and recommendations are to evaluated under Regulation Best Interest (Reg BI)6, not a true fiduciary standard.
The resulting quality of advice issues are obvious:
- The fiduciary standard requires that an adviser consider the prudence of their actions/recommendations in terms of an “open architecture” platform, or the entire universe of investment options, to ensure that the best interests of the plan participants are genuinely protected.
- Reg BI, and its “readily available alternatives” loophole, allows plan advisers to “carve out” a portion of the universe of investment options and essentially put the best interests of the broker-dealer and the plan adviser ahead of those of the plan and its participants.
This result is totally inconsistent with ERISA’s stated purpose and mission, to protect plan participants and retirement plans against any form of inequitable or abusive activity.
In analyzing cases involving fiduciary disclaimer clauses, my initial response is to ask (1) why a plan adviser would even request such a provision, and (2) why would a plan sponsor agree to such a provision.
Releasing a plan adviser from any fiduciary duties or obligations to a plan does not provide any benefits at all to plan participants. Not only does it allow a plan adviser to provide a lesser quality of advice and products pursuant to Reg BI, it also arguably allows them to avoid offering their company’s entire line of financial products to the plan participants, potentially denying the plan participants the opportunity to maximize their potential return by investing in cost-efficient investments. Therefore, agreeing to any plan advisory contract that contains a fiduciary disclaimer clause violates a plan sponsor’s fiduciary duties of loyalty and prudence.
I would argue that prior to agreeing to any fiduciary disclaimer clause, a plan sponsor should consider the fact that the financial services industry has historically opposed any attempt to impose a true fiduciary standard on its members. Could it be because the industry knows that their advice and products typically fall far short of complying with a true fiduciary standard, while Reg BI arguably protects them when providing imprudent advice and/or products?
Section 90, comment h(2), of the Restatement states that that due to the higher costs and risks associated with actively managed funds and active strategies, both are imprudent unless it can be objectively estimated that the funds and/or strategies will provide a commensurate return for the additional costs and risks incurred, i.e., are cost-efficient.7
The financial services industry does not like to discuss cost-efficiency, as studies have consistently shown that the overwhelming majority of actively managed mutual funds are cost-inefficient.
- 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.8
- 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.9
- [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.10
- [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.11
The CommonSpirit case presents a perfect example of this scenario in connection with the comparison between the Fidelity Freedom active suite of target-date funds and the Fidelity Freedom Index target date funds. A forensic analysis comparing the 2035 version of both funds using the Active Management Value Ratio™ clearly shows that the 2035 active version of the funds is cost-inefficient relative to the passive index version.
An AMVR analysis comparing the other Fidelity Freedom active/Freedom Index funds provided similar results
Had the CommonSpirit plan adviser remained subject to a fiduciary standard, it can be argued that the adviser would have been equally legally liable, along with the plan sponsor, for not recommending and selecting the cost-inefficient, i.e., imprudent, funds to the plan. The inability of the plan participants to include the plan adviser in any litigation could also impact their ability to achieve a full and complete recovery for any and damages suffered.
From a strategic standpoint, the inclusion of a claim based on the fiduciary disclaimer theory could also benefit ERISA plaintiff attorneys in preventing dismissal of their cases by creating a genuine and material issue of fact. On ruling on motions to dismiss, judges are required to accept plaintiff’s allegations of fact as true and to base their decisions involving such motions only on questions of law. A basic tenet of the law is that decisions of fact are to be made solely by a jury.
Furthermore, given the fact that the plaintiff will rarely have pre-trial access to the advisory contract between the plan and the adviser, the Leber v. Citigroup 401(k) Investment Committee decision12 should be cited as authority for granting plaintiff’s attorney restricted discovery on the issue of the advisory contract prior to the court deciding a motion to dismiss.
3. When I read the Sixth Circuit’s CommonSpirit decision, two other 401(k) decisions immediately came to mind, Brotherston and Hughes v. Northwestern University.13 The reasons these cases came to mind is that they support my advice to plan sponsors and other investment fiduciaries to follow the actual law, not the interpretations of the law by the courts.
My advice is not meant as disrespect for the courts. My advice is simply meant as a risk reduction reminder to plan sponsors and other investment fiduciaries that courts can, and sometimes do, legitimately interpret the application of the law differently due to a difference in the facts involved in a case.
Courts are also not infallible. As Justice Benjamin Carozo pointed out,
There is in each of us a stream of tendency, whether you choose to call it philosophy or not, which gives coherence and direction to thought and action. Judges cannot escape that current any more than other mortals.
The great tides and currents which engulf the rest of men do not turn aside in their course and pass the judges by.
The law, however, should remain constant. And in interpreting and applying the law, I agree with Justice Cardozo that in many cases, “[t]he risk to be perceived defines the duty to be obeyed.”
In the Northwestern University case, we saw SCOTUS reject the Seventh Circuit’s “menu of options” argument based solely on the wording of ERISA itself. In Brotherston, we saw the First Circuit reject the lower court’s “apples and oranges” argument solely on the wording of Section 100, comment b(1), of the Restatement (Third) of Trusts.
In the CommonSpirit case, we have two Courts of Appeal that have issued two diametrically opposed and irreconcilable decisions involving the same law and the same issue, the propriety of using index funds for benchmarking purposes in determining damages in 401(k) litigation cases.
Only time will tell what the eventual outcome of the case will be. In the meantime, I believe the case provides a valuable lesson as to why plan sponsors and other investment fiduciaries should always focus primarily on the actual laws, not judicial interpretations of such laws
As the Solicitor General pointed out in the amicus briefs filed with SCOTUS in both the Brotherston and Northwestern University cases, inconsistencies between the federal Courts of Appeal is simply one that cannot be allowed to stand, especially in ERISA cases where the financial security of employees and their families are involved.
1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022). (CommonSpirit)
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018). (Brotherston)
3. RESTATEMENT (THIRD) TRUSTS, (American Law Institute). (All rights reserved).
4. Brotherston, 39.
5. Tibble v. Edison International, 135 S. Ct 1823 (2015).
6. SEC Release 34-86031, Regulation Best Interest: The Broker-Dealer Standard of Conduct (Reg BI), 279.
7. RESTATEMENT (THIRD) TRUSTS, (American Law Institute), Section 90, cmt h(2). (All rights reserved).
8. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANE 179, 181 (2010).
9. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8e
10. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997).
11. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016.
12. Leber v. Citigroup 401(k) Plan Inv. Committee, 2014 WL 4851816.
13. Hughes v. Northwestern University, 142 S.Ct. 737 (2022).
Copyright InvestSense, LLC 2022. All rights reserved.
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
Pingback: An Inconvenient Truth: Cost-Inefficiency and Closet Indexing in 401(k) Plans | The Prudent Investment Fiduciary Rules