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

The courts have consistently recognized the inherent conflict of interest that exists in the investment industry between investment advisers/consult and clients:

“In this conflict of interest, the law wisely interposes. It acts not on the possibility, that, in some cases, the sense of that duty may prevail over the motives of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.”¹

In his new book, “Investing in U.S. Financial History: Understanding the Past to Forecast the Future,” Mark Higgins addresses the issue of investment consultants and conflicts-of-interest. Prior to publication, Higgins was kind enough to allow me to review the chapter that addresses such inherent conflicts of interest, He correctly identifies the basic problem with investment consultants, namely overstating their value propositions, with “[t]he inevitable outcome [being] subpar preformance and higher fees,”, in other words, cost-inefficiency.²

Higgins reportedly spent over four years researching his book, as evidenced by the fifty pages of footnotes. His book is an incredible resource for the financial services industry, investment advisers, attorneys, and investors in general.

The Devil Is In the Details
As a fiduciary risk management consultant, part of my services includes educating my clients on the potential fiducairy liability issues resulting from conflicted investment advice and how to detect such tainted advice. Fortunately, the Active Management Value Ratio^TM (AMVR) metric makes it relatively easy to detect and address such conflicted advice.

The AMVR is based on the investment research and concepts of investment icons such as Charles D. Ellis and Nobel laureate Dr. William F. Sharpe. The AMVR allows investment fiduciaries to follow the Restatement (Third) of Trusts’ standards by evaluating the prudence of an actively managed fund in terms of commensurate return relative to the increased costs and risks commonly associated with actively managed funds.

Dr. Sharpe is on record as saying the best way to evaluate the performance of an actively managed mutual fund is to compare the active fund to a comparable index fund.³ The sample AMVR slide shown here is a good example of conflicte advice, as it compares two Fidelity large cap growth funds, the K shares of the popular Fidelity Contrafund Fund (Contrafund) and the shares of Fidelity’s Large Cap Growth Index Fund (LCG). The slide demonstrates how the AMVR provides several methods of detecting potentially conflicted advice.

1. A basic cost/benefit analysis shows that the Contrafund underperformed the LCG fund and resulted in excess costs of approximately 43 basis points. (A basis point is equal to 1/100th of 1 percent.)

2. Actively managed mutual funds typically combine the fees for active and passive management, making it difficult for investment fiduciaries and investors to determine the cost-efficiency of the active management component of the fund.

Ross Miller’s Active Expense Ratio⁴ provides a means for investment fiduciaries to separate the two fees and to determine the implicit cost of the active management component. In this case, the AMVR indicates that the implicit cost of the fund’s active management component is 3.48, over 7 times greater than the fund’s stated expense ratio.

3. Using InvestSense’s proprietary Fiduciary Prudence Ratio^TM (FPR) , Contrafund’s FPR score would be zero since the FPR’s numerator is the positive incremental return provided by an the actively managed fund. Contrafund underperformed the benchmark LCG fund, resulting in Contrafund’s FPR score of zero relative to the benchmark.

It should be noted that Fidelity reportedly does not make the LCG index fund available to pension plans. My guess is that they fear that the LCG fund would essentially cannibalize the Contrafund given the LCG fund’s superior performance and lower fees.

The fiduciary risk maangement point here is that Fidelity has no obligation to make the LCG fund available to pension plans. However, plan advisers and other investment consultants providing services and/or advice to pensions plans in a fiduciary capacity do have an obligation to pension plans to properly investigate their recommendations and only recommend those funds that are cost-efficient and otherwise legally prudent under all applicable laws and regulations.

The fact that the LCG index fund is not made available in no way justifies a breach of one’s fiduciary duties of loyalty and prudence by recommending a legally questionable second choice. Despite what the investment industry may want you to believe, a cost-inefficient mutual fund is never a legally acceptable “choice.”

Annuities, Conflicted Advice, and Breakeven Analysis
Conflicted investment advice is normally thought of in terms of advice which promotes the investment adviser’s best interests ahead of those of the investor. Since plan sponsors and other investment fiduciaries must satisfy their fiduciary duties of loyalty and prudence,

Breakeven analysis is especially effective in exposing conflicted annuity advice. Annuity advocates constantly use the marketing line of “guaranteed income for life.” Before even considering any type of an annuity, an investment fiduciary’s response to such marketing should always be “at what cost?” Breakeven analysis is an effective method of answering that question and exposing conflicted advice.

Shown below is an example of the sort of breakeven analysis plaintiff attorneys often use in cases involving catastrophic injuries and significant damages. The insurers and their defense attorneys often propose the use of annuities in such cases to prevent the insurer from having to payout a very large sum at one time.

When I first posted this analysis, I included similar analyses using interest rates of 4 and 6 percent. A mistake that insurance advocates make when presenting such breakeven analyses is to forget to discount the value of the annuity in terms of both present value and mortality risk. Mortality risk addresses the odds that the annuity owner will even be alive to receive the annuity’s annual payment. As the chart shows, factoring in mortality risk has a significant impact of when, or if, an annuity owner will even break even.

However, the conflict of interest issues and the insurer’s intentional fraudulent conduct was finally exposed when they were challenged by the plaintiff and the court as to the source of their statistics. The insurer admitted that they had lied, that there was not, and never had been, any studies substantiating their rapid dissipation claim.⁵

Similarly, current advocates for annuities based on the “guaranteed income for life” mantra try to avoid discussing the potential liability risk management topics that investment fiduciaries should focus on – breakeven analysis and commensurate return. More often than not, a breakeven analysis reveals that the odds are against an investor in such products breaking even and receiving a commensurate return, due primarily to the underlying design of and excessive fees commonly associated with such products.

The chart shown above is a “pure insurance” analysis. When I first published the chart online, some annuity advocates immediately pointed this fact out, claiming that current securities-related annuities provide a better and fairer return. But do they?

Conflicts of Interest, Framing, and Bayesian Theory
“Framing” refers to the manner in which a question or product is presented, often with the goal of ensuring a certain response For instance, “would you like to receive guaranteed income for life?” Who wouldn’t?

Investment fiduciaries must always factor in fiduciary duties and potential fiduciary liability exposure. As a result, I suggest more appropriate, realistic and liability-driven ways of framing the “guaranteed income for life” question. For example, I often frame the value of a variable annuity as follows:

A variable annuity can provide a stream of income for life. However, in order to receive such benefit you will be required to annuitize your variable annuity, to surrender ownership and control of the annuity contract, as well as the accumulated value of the annuity itself, with no guarantee that you will ever receive a commensurate return on your investment.

While a variable annuity usually provides a death benefit in the event that, at the time of your death, you have not anuitized your variable annuity and the value of the annuity is less than your your actual investment in the annuity. The death benefit is not free. You will be charged an annual fee, a so-called mortality fee, to supposedly cover the annuity issuer’s cost of covering their potential liability under the death benefit. However, many annuity issuer’s base their annual mortaility fee calculations on the current accumulated value of the variable annuity rather than their actual legal/contractual death benefit liability, which, again, is typically limited to the owner’s actual contributions to the annuity, a figure which is typically significantly less that the variable annuity accumulated value as a result of the returns earned via the variable annuity’s subaccounts.

This practice of basing the annual mortality fee on the annuity’s accumulated value, commonly known as inverse pricing, often produces a signnificant windfall for the annuity issuer at the annuity owner’s expense. If an investment fiduciary is involved in the ecommendation and/or sale of a variable annuiy that uses inverse pricing, many consider this a clear violation of the fiduciary duties of loyalty and prudence.

One additional thing that variable annuity advocates often fail to mention with reagrd to variable annuities is that the investment subaccounts offered within a variable annuity are often actively managed mutual funds, perhaps even proprietary mutual funds of the annuity issuer and/or an affiliated subsidiary. Research has consistently shown that actively manged mutual funds are overwhelingly cost-inefficient, meaning they consistently underperform and charge higher fees than comparable index funds.

Still want to provide variable annuities within your defined contribution plan?

The framing example I just provided is an example of what is known as the Bayesian Theory. Bayesian theory suggests that the odds of making a correct decision increase with each relevant and accurate piece of information provided to the decision-maker. The framing example definitely provides more meaningful information for an investment fiduciary to process in the investment decision process.

Bayesian theory is consistent with ERISA’s concern with sufficient and meaningful disclosure to allow plan particicipants to make informed decisions. Bayesian theory essentially argues that the more meaningful information provided, the better the chnacesof making an accurate decision. One can also argue that greater transparency called for by the Bayesian Theory is the antithesis of the financial service and annuity industries positions on disclosure.

Simply touting “guaranteed income for life” hardly discloses a complete and accurate list of factors that plan spsonors and other investment fiduciaries must consider in choosing prudent investment options. As a result, plan spsonsors and other investment fiduciaries are often exposed to unnecessary fiduciary liability

Going Forward
So why have I taken the time to discuss Bayesian Theory, probabilty, breakeven analyses, cost-efficiency, and commensurate return First, as a fiduciary risk mangement consultant, I consider these topics to be an intergral part of my services and responsibilities to my clients, my value-added proposition.

Second, I believe that we are going to see a signficant change in the areas of ERISA and basic fiduciary litigation. Hopefully, that change will begin with SCOTUS having an opportunity to review the Home Depot 401(k) decision and render a decision that will result in greater uniformity in the interpretation and enforcement of ERISA’s protections and guarantees. If this does come true, I anticipate seeing a significant and immediate increase in ERISA-related litigation, both in terms of plan participant/plan sponsor litigation and plan sponsor/plan adviser litigation.

As part of a plan sponsor’s fiduciary duties of loyalty and prudence, ERISA requires plan sponsors to perform an independent and objective investigation and evaluation of each investment option chosen for a pension plan. Basic fiduciary law requires the same standards for investment fiduciaries in general.

I advise all of my fiduciary risk management clients to insist that a plan consultant/plan adviser justify all recommendations with either a written AMVR analysis, strictly following the model that InvestSense created, with no so-called “improvements,” or, in the case of annuities, a written breakeven analysis of any recommended annuity, including all assumptions and data upon which the breakeven analysis was based.

In the case of variable annuities, fixed indexed annuities and any other annuity whose returns are tied to the stock market and/or market indices, I advise my clients to insist on a comparison to the performance of the underlying index over specific time periods, e.g., 5 and 10 years, specific information as to the amount of any spreads that will assessed by the annuity issuer, and a simple, plain English explanation of the interest crediting methodolgy that the annuity issuer will use. This information will hopefully allow plan sponsors to provide the “sufficient information” required under ERISA 404(c), and thereby qualify for the “safe harbor” protections offered by Section 404(c).

Notes
1. Hughes v. Securities and Exchange Commission, 174 F.2d 969, 975 (D.C. Cir. 1949)
2. Higgins, Mark J., Investing in U.S. Financial History: Understanding the Past to Forecast the Future. Greenleaf Book Group Press: Austin, TX, 2024, 420-421.
3. William F. Sharpe, “The Arithmetic of Active Investing,” https://web.stanford.edu/~wfsharpe/art/active/active.htm.
4. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926.
5. Jeremy Babener, “Structured Settlements and Single-Claimant Qualified Settlement Funds: Regfulating in Accordance With Structured Settlement History,” New York University Journal of Legislation and Public Policy, Vol . 13, 1 (March 2010)

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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.