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

Simplicity is the new sophistication. – Steve Jobs

Complexity is job security. – Rick Ferri

I recently conducted a fiduciary prudence audit for a 401(k) plan. During the review of my audit findings, I focused on two significant issues:
1. The inclusion of a variable annuity in the plan, and
2. The inclusion of duplicate mutual funds in the plan, resulting in the inclusion of numerous cost-inefficient funds.

The duplicity of funds is easy to resolve. When it comes to 401(k)/403(b) compliance and risk management, less is usually more as long as a prudent selection process is used.

Variable Annuities in Plans
In my opinion, nothing raises a 401(k) compliance red flag more than the inclusion of an in-plan annuity. I have written several posts on the issues of the inclusion of annuities in plans. Chris Tobe, one of my co-founders of the web site, “The CommonSense 401(k) Project,” has posted several articles on the site with regard to the inherent fiduciary issues with annuities. Chris previously worked at a well-known annuity distributor designing annuities.

Rather than repeating all the issues discussed in our previous posts, I will just provide a few of the key risk management issues that plan sponsors should consider before including an in-plan annuity within their plan:

1. Duplicative Tax Benefits – A 401(k)/403(b) plan already provides plan participants with the benefit of deferred taxation. So, an in-plan annuity does not provide a benefit in that regard.
2. Lack of an ERISA Requirement – Neither ERISA nor any other law requires that a plan offer an in-plan annuity within their plan. I have heard stories about annuity advocates falsely representing that the SECURE Act and SECURE 2.0 require a plan to offer annuities and/or guaranteed retirement income products within a plan. Simply not true.

ERISA Sections 404(a)¹nd 404(c)² do not require that any specific category of investments be offered within a plan. Both sections simply require that each investment offered within a plan be legally prudent. The most common standards for determining legal prudence are the fiduciary prudence standards established by the Restatement of Trusts (Restatement).
3. Impact on Participant Fees – In reviewing potential investment options for a plan, a plan sponsor should focus on the cost-efficiency of the investment. Plan sponsors often only focus on nominal, or reported, returns. However, the Restatement emphasizes the importance of cost-consciousness/cost-efficiency.³

The Department of Labor recently filed an amicus brief in the pending Home Depot 401(k) litigation.# They summed up a fiduciary’s duties vis-à-vis perfectly, citing several provisions from the Restatement.

The judgement and diligence required of a fiduciary in deciding to offer any particular investment must include consideration of costs, among other factors, because a trustee ‘must incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.⁴

Variable annuities are especially insidious in assessing inappropriate and inequitable fees. For example, many annuity issues assess annual fees to supposedly cover the cost of the variable annuity’s death benefit. However, the annuity issuers often base the annual death benefit fee on the accumulated value of the annuity, even though annuity issuers often limit their liability under the death benefit to the amount of the variable annuity owner’s actual contributions to the annuity. 

As a result of this deceptive practice, known as “inverse pricing,” the annual death benefit fee is neither reasonable nor appropriate, thereby resulting in a violation of a plan sponsor’s fiduciary duties. The fact that this also results in a windfall for the annuity issuer at the annuity owner’s expense is an additional violation of a plan sponsor’s fiduciary duties of prudence and loyalty.

When I asked the plan sponsor what factored in the plan’s decision to include the variable annuity in the company’s, he responded that he simply wanted to help his employees and, based on what the plan adviser had told him, the annuity would help his employees.

This is consistent with a recent LIMRA article, “Are In-Plan Annuities at a Tipping Point?”⁶ The article evaluated common reasons that employers offered for offering in-plan annuities. The top three reasons were

• Feel obligation to help employees generate income in retirement – 43%
• Recommendation of plan consultant/advisor – 39%
• Feel best place to generate retirement income is from the plan – 37%

As for the first and third reasons, as previously discussed, there is simply no such obligation legally. Nice thought, but poor judgment in terms of fiduciary risk management given the excessive fees and often cost-inefficient investment subaccounts offered within the annuity,

The fact that the plan participant will typically be required to annuitize the annuity contract to receive the guaranteed stream of income, surrendering both control of the annuity and ownership of the value within the annuity to the annuity issuer, with no guarantee of receiving a commensurate return, raises obvious question with regard to the plan sponsor’s fiduciary duties of prudence and loyalty.

The second reason raises a number of interesting questions. Mark Higgins of Index Fund Advisers has recently written an article on the issue of quality of advice provided by plan advisers. In “The Unspoken Conflict of Interest at the Heart of Investment Consulting,”⁷ Higgins specifically addresses plan advisers’ conflicts-of-interest and the need for plan sponsors to be aware of and address such issues to avoid unnecessary fiduciary liability exposure.

Higgins recommends that trustees and other investment fiduciaries recognize that the advice they receive from investment consultants is often tainted by conflicts of interest which calls into question the basic value of such advice. Once fiduciaries recognize the conflict-of-interest issue, Higgins suggests that fiduciaries search for less complex and less costly strateg[ies’]

Higgins has also recently written a book, “Investing in U.S. Financial History: Understanding the Past to Forecast the Future “, which is scheduled for release on February 27. One of the chapters in his book addresses the issue of the complexity often associated with advice from investment consultants, which would include plan advisers.

Higgins was kind enough to let me read the chapter from his book which addresses the unnecessary complexities that advisors and consultants build into their advice. Rick Ferri’s quote at the beginning of this post suggests that the inclusion of such complexities is deliberately self-serving, and further proof of the conflict-of-interest plan sponsors, trustees, and other investment fiduciaries must deal with. The late Charlie Munger had a similar quote – “Show me the incentives and I’ll show you the outcome.”

Higgins and I are both fans of investment icon Charley Ellis. Higgins perfectly sums up Chapter 25, “Manufacturing Portfolio Complexity,” and the never-ending challenges investment fiduciaries and investors fact with this quote from Ellis:

Consultants’ agency interests…are economically focused in keeping the largest number of accounts for many years as possible. These agency interests are not well aligned with the long-term principal interests of the client institution.

Going Forward

As a general rule, the more complexity that exists in a Wall Street creation, the faster and further investors should run. – David Swensen⁸

Simplicity is the hallmark of truth – we should know better, but complexity continues to have a morbid attraction….The sore truth is that complexity sells better.” – Morgan Housel⁹

Swensen’s and Housel’s quotes are equally applicable for plan sponsors and other investment fiduciaries. Prudent fiduciaries do not expose themselves to unnecessary complexity or fiduciary risk. One of Warren Buffett’s basic tenets is that an investor should not invest in anything they do not understand.

Higgins has written a valuable contribution to the ongoing battle for investor protection and the development of fiduciary law. Higgins basically argues that investors and investment fiduciaries should avoid the unnecessary complexity, and the conflicts-of-interest, that are often built into modern investments.

For my part, I have developed two simple, yet powerful, metrics, the Active Management Value Ratio™ and the Fiduciary Prudence Ratio™, to provide investment fiduciaries, investors, and attorneys with a means of quickly assessing whether actively managed mutual funds are truly in the best interest of their clients and themselves.

The byline on my sister site, “CommonSense InvestSense, is “the power of the Informed Investor.” As my discussion about the inclusion of an in-plan annuity suggests, far too often investment fiduciaries may find themselves facing unwanted fiduciary liability due to the failure of a plan advisor to provide material information to the plan sponsor and/or the plan sponsors’ failure to ask necessary questions due to the plan sponsor’s lack of experience with and/or understanding of important investment principles.

Transparency and disclosure are the financial services industry’s kryptonite. Such lack of transparency and disclosure is often deliberate to hide the conflicts-of-interest and unnecessary complexity that Higgins discusses in his book.

Plan sponsors need to remember this in dealing with stockbrokers and insurance agents. The courts have consistently warned plan sponsors that they cannot blindly rely on third parties.

I always advise my fiduciary risk management clients to insist that their plan advisor document all advice provided, and the reasoning behind same, in writing. Many advisors refuse to do so, knowing the true quality of their advice. Refusal to provide such documentation should be an immediate red flag to a plan sponsor.

P.S. Whenever I give a presentation about the perils of offering in-plan annuities within a plan, I typically get follow-up emails or calls asking for help in addressing the problem. As a former securities compliance director, I am all too familiar with the problem with annuities, as our brokers often obtained new customers that had been convinced to purchase an unsuitable annuity.

There are possible solutions to addressing the in-plan annuity conundrum. However, plan sponsors should not attempt to resolve such problems without the aid of an experienced securities attorney, a knowledgeable ERISA attorney, and possibly a good tax attorney.

Notes
1. 29 U.S.C.A. Section 404a; 29 C.F.R Section 2550.404a-1(a), (b)(i) and (b)(ii).
2. 29 C.F.R. § 2550.404(c); 29 U.S.C. § 1104(c).
3. Restatement (Third) of Trusts, Section 90, cmt. b, cmt. f, and cmt. h(2). American Law Institute. All rights reserved. (Restatement)
4. Restatement, Section 90(c)(3) and 90 cmt. b (“[C]ost-consciousness management is fundamental to prudence in the investment function”).
5. https://blogs.cfainstitute.org/investor/2024/01/25/the-conflict-of-interest-at-the-heart-of-investment-consulting__trashed/
6. https://www.limra.com/en/newsroom/industry-trends/2023/are-in-plan-annuities-at-a-tipping-point/
7. https://blogs.cfainstitute.org/investor/2024/01/25/the-conflict-of-interest-at-the-heart-of-investment-consulting__trashed/
8. https://yalealumnimagazine.org/articles/2398-david-swensen-s-guide-to-sleeping-soundly David Swensen, “Unconventional Success: A Fundamental Approach to Personal Investment,” (Free Press 2005).
9. Morgan Housel, Same as Ever: A Guide To What Never Changes (USA: Penguin, 2023).

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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.