By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

“Living is easy with eyes closed
Misunderstanding all you see…”
“Strawberry Fields Forever” – The Beatles

In my role as a fiduciary risk management counsel, I constantly see plan sponsors and other investment fiduciaries exposing themselves to unnecessary liability exposure simply because they do not truly understand what their fiduciary duties. A perfect example is the current situation with the annuity industry promoting, in some cases reportedly misleading plan sponsors, on the inclusion of annuities in 401(k) and 403(b) plans.

ERISA does not require a plan to offer annuities within a 401(k) or 493(b) plan. In fact, Section 404 of ERISA does not expressly require a plan to offer any specific type of investment option. Section 404 simply requires each investment option offered within a plan to be prudent.

(a) Prudent man standard of care

(1) [A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and—
(A) for the exclusive purpose of:
(i) providing benefits to participants and their beneficiaries; and
(ii) defraying reasonable expenses of administering the plan;
(B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;

Some of my clients report that some annuity advocates have stated that plan sponsors have a moral duty to offer annuities within a plan. Simply not true.

I am on record as saying that I believe that the next 12-18 months is going to dramatic changes in the area of 401(k) and 403(b) litigation, with increased litigation between plan sponsors plan participants, well as between plan sponsors and plan advisers. The first signs appeared in connection with the First Circuit Court of Appeals’ Brotherston case¹, in the form of both the decision itself and the Solicitor General’s amicus brief² that was filed with SCOTUS when Putnam Investments asked the Court to review the case.

I have written several lengthy posts analyzing both the decision and the Solicitor General’s amicus brief. In short, both the First Circuit and the Solicitor General agreed that (1) the burden of proof as to the causation of losses in 401(k) litigation belongs to the plan sponsor, not the plan participants, and (2) that index funds and market indices can be used as comparators in 401(k) litigation in computing losses/damages sustained by plan participants.

The Department of Labor (DOL) recently filed an amicus brief in a pending 401(k) case.³ Citing the common law of trusts, the DOL agreed with both the First Circuit and the Solicitor General as to which party bears the burden of proof on the issue of causation in 401(k) litigation. The DOL further argued that that position is currently the prevailing opinion in the majority of the federal circuits.. The DOL’s position could play a significant role in deciding both the Home Depot and the Matney cases, both of which are currently pending in federal courts.

ERISA Plaintiff’s Exhibit A
As I tell all my fiduciary risk management clients and ERISA plaintiff attorneys, the key to fiduciary prudence is to focus on cost-efficiency, not on the active/passive debate. A friend and colleague of mine, Preston McSwain of Fiduciary Wealth Partner, recently sent me a link to a YouTube video that he thought I would find interesting, The video, “Greenwich Roundtable-Pure Passive: Risks and Rewards,” features the former CIO of Exxon’s $30 billion defined benefit plan. He explains how and why the plan switched to an all-index funds approach and how it benefitted both the company and the plan participants.

A couple of years ago, I created a simple metric, the Active Management Value Ratio^TM (AMVR). The AMVR allows fiduciaries, investors, and attorneys to quickly and easily evaluate the cost-efficiency of an actively managed fund. The AMVR is based on the research of well-respected investment experts such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, Burton G. Malkiel, and Ross Miller.

The video provides further evidence of the importance of cost-efficiency in satisfying a plan sponsor’s fiduciary duty of prudence and how easy it is to achieve using only index funds. The AMVR makes it even easier for plan sponsors to comply with their fiduciary duty of prudence, as explained here and here.

Going Forward
With the DOL’s recent amicus brief, I firmly believe that the question as to the burden of proof on the issue of causation of losses shifting to plan sponsors is not a question of “if,” but rather “when.” I believe that SCOTUS will eventually be called on to decide on one consistent standard on the issue so that the rights and protections guaranteed under ERISA will be uniformly applied in the legal system. At that point, it will be extremely difficult for plan sponsors to justify the use of cost-inefficient actively managed funds.

As Judge Kayatta noted in the Brotherston decision, plan sponsors should choose index funds if they wish to avoid unnecessary liability exposure, he was simply telling the truth. Judge Kayatta’s position has been consistently supported by studies on the cost-efficiency of actively managed funds, studies with findings such as

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.⁴  

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.⁵

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁶

[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.⁷

Judge Kayatta’s position is further supported by John Langbein, who served as the Reporter on the committee that wrote the Restatement (Second) of Trusts over fifty years ago. Shortly after the release of the revised Restatement, Langbein wrote a law review article on the new Restatement. At the end of the article, he made a bold prediction:

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.⁸   

I would suggest that that time is here and that the Greenwich Roundtable video shows how and why index funds will be the applicable standard for prudent plan sponsors and other investment fiduciaries. The question right now for plan sponsors and other investment fiduciaries is whether they will be able to carry the burden of proof as to causation of damages, whether they will be able to prove that their choices did not cause any losses suffered by a plan’s participants. The prudent plan sponsor will promptly audit their plans using the AMVR to determine the extent of any potential liability – and whether Exxon’s all-index fund strategy should be considered.

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
2. https://www.justice.gov/osg/brief/putnam-invs-llc-v-brotherston
3. https://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
4. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
5. 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. 
6. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
7. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
8. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498

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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.