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

A [fiduciary] is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is the standard of behavior….¹

Consistent with fiduciaries’ obligations to choose economically superior investments,.. [P]lan fiduciaries should consider factors that potentially influence risk and return.²

Fiduciary law is a combination of three types of law–trust, agency and equity. The basic concept of fiduciary law is fundamental fairness.

SCOTUS has consistently recognized the fiduciary principles set out in the Restatement (Third) of Trusts (Restatement) as guidelines for fiduciary responsibility, especially for plan sponsors.

ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.²

Under the Restatement, loyalty and prudence are two of the primary duties of a fiduciary. A fiduciary’s duty of loyalty requires that a plan sponsor act solely in the best interests of the plan participants and their beneficiaries. A fiduciary’s duty of prudence requires that a plan sponsor exercise reasonable care, skill, and caution in managing a plan, specifically with regard to controlling unnecessary costs and risks.

The key question in evaluating annuities, or any other investment, should always be “at what cost?” With annuities, you generally have annual costs as well as additional optional costs for various “bells and whistles.” While costs vary, a basic average annual cost for immediate annuities seems to be 0.7 percent. The average costs for various additional options with all annuities seems to be an additional 1.0 percent. However, it is a plan sponsor’s duty to always ascertain the exact costs.

Plan sponsors need to always remember this mantra – “Costs matter.” Costs do matter, a lot. The General Accounting Office has stated that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a twenty year period. ³

Against that backdrop, plan sponsors are now confronted with the potential issues of including annuities and within a 401(k) plan, even thought these is no legal, moral, or other type of requirement to do so. I believe that annuities are inappropriate for 401(k) and 403(b) plan sponsors, as well as other investment fiduciaries such as registered investment advisers and trustees and are potential fiduciary liability traps, as they are structured to best serve the annuity issuer’s “best interests,” not those of an annuity owner. The following example of a typical income annuity shows a breakeven analysis for a 65-year old purchasing a garden-variety income annuity

Annuities
An exhaustive analysis of annuities is beyond the scope of this post. I simply want to address three of the most common types of annuities and some of the fiduciary issues associated with each. One of the fiduciary issues involved with annuities is their complexity. The analyses herein will be based on the simple, garden variety of each of the three annuities.

1. Immediate Annuities (aka Income Annuities}
These annuities are often recommended to provide supplemental income in retirement. In most cases, immediate annuities can be used to provide income for life or for a certain period of time, e.g., 5, 10, 15 or 20 years.

Peter Katt was an honest and objective insurance adviser. During my compliance career, he was my trusted go-to resource. While he passed away in 2015, the lessons I learned from him will always be invaluable. I strongly recommend to investors and investment fiduciaries that they Google his name and read his articles, especially those he wrote for the AAII Journal.

Katt’s thought on immediate annuities include:

The immediate annuity is for people who want the absolute security that they can’t outlive their nest egg. The problem is that there is nothing left over for your heirs.⁴

While annuities often offer options to address this issue, such options often result in reduced monthly payments and/or additional costs.

Katt always said to get the annuity salesmen to provide a written analysis providing the breakeven analysis for an annuity, the estimated time that would be required for an annuity owner to recover their original investment in the annuity. He told me that breakeven periods of twenty years or more are common, making it unlikely that the annuity owner will ever recover their original investment. And remember, with a life-only immediate annuity, once the annuity owner dies, the balance in the annuity goes to the annuity issuer, not the annuity owner’s heirs.

The sample breakeven analysis shown below shows the odds a 65 year old purchasing a simple income annuity paying 5 percent annually would face of not even breaking even, even if they lived to be 100. The example shows why it is importance to factor in both present value and mortality risk in evaluating the prudence of a garden-variety annuity.

If at some point, the annuity owner realizes that they made a mistake and wants to get out of the annuity by selling it, the purchaser, at best, is going to base the offering price on the annuity’s present value, not the original face value. In some cases, the purchaser will discount the offering price even further, using the mortality risk-based value.

This is why I often refer to the annuity industry’s attempt to make courts order that cases involving significant amounts of money include “structured settlements” that include annuities, what I refer to as “victimizing the victim.” For years, the annuity industry mislead the courts in an effort to persuade courts to require settlements to include annuities by claiming to have research showing that over 90 percent of plaintiffs receiving large sums outright squandered the money within 5 years. When finally pressed to produce such research, the annuity industry admitted that there was no such research.⁵

Katt also said to always ask the annuity salesman for the APR that was used in calculating the breakeven point. The APR is the interest rate that annuity issuers typically use in determining an annuity’s payments. In the example above, the applicable APR is 5 percent.

One of the drawbacks with immediate annuities is that once an interest rate is set, that will be the applicable interest rate for the period of the annuity. Again, some annuities may offer options to avoid this inflexibility…at an additional cost.

The inflexibility of an annuity’s interest rate results in purchasing power risk for an annuity owner. This risk increases as the period of the annuity increases. Purchasing power risk refers to the risk that the annuity’s payments will lose their buying power over the years due to inflation. Some annuities provide for “step-ups” in rates…at an additional cost.

Katt’s advice-anyone considering an immediate annuity should first build a balanced portfolio consisting of stocks and bonds to ensure flexibility, and then invest augment that portfolio with a reasonable am0unt in the immediate annuity. While some annuity salesmen will argue for an “all or nothing” approach in order to maximize their commission. Prudent investors will follow Katt’s advice.

Perhaps the strongest argument against including immediate annuities in 401(k) and other pension plans comes from a study by three well-respected experts on the subject. In analyzing when a Single Premium Immediate Annuity (SPIA), probably the most popular type of immediate annuity, would make sense, the three experts stated that

Results suggest that only when the possibility of outliving 70 percent or more of a cohort exists, and then only at elderly ages. For ages younger than 80, assets are best kept within the family, because both inflation and possible future market returns have time to do better than SPIA lifetime sums.⁶

Based upon my experience, very few 401(k) plans have plan participants aged 80 or older. I predict that plan sponsors who decide to offer immediate annuities, in any form, in their plans can expect to see that quote again, especially cases involving litigation.

2. Fixed Indexed Annuities (aka Equity Indexed Annuities)
Target date funds (TDFs) are controversial investments that attempt to create investment portfolios that are appropriate based on the investor’s estimated retirement, or target, date. Target date funds have typically designed portfolios consisting of equity and fixed income investments.

There have been reports suggesting that the annuity industry may be trying to include some form of equity indexed annuities (EIAs) as an element in TDFs in 401(k) and 403(b) plans. So, what would be wrong with that? Dr. William Reichenstein, finance professor emeritus at Baylor University sums up the primary issue perfectly.

The designs of equity index annuities (EIAs) and bond indexed annuities ensure that they must offer below-market risk-adjusted returns compared with those available on portfolios of Treasurys and index funds. Therefore, this research implies that indexed annuity salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.⁶

While EIAs/FIAs are technically insurance products, not securities, Dr. Reichenstein’s analysis is still applicable with regard to a fiduciary’s duties of loyalty and prudence. If the design of these products ensures that they cannot offer competitive returns to those of alternative investments, then how does a plan sponsor, or any fiduciary for that matter, plan to meet their fiduciary duty of loyalty and prudence? Would the inclusion of EIAs in either TDFs, or in 401(k) plans in general. potentially create unnecessary fiduciary liability exposure for plan sponsors or other investment fiduciaries,

As regulators emphasize, before an insurance agent can sell an annuity, he or she must perform due diligence to ensure that the investment offered ex ante competitive returns. Therefore, it is appropriate to compare the net returns available in an equity-indexed annuity to those available on similar-risk investments held outside an annuity.⁷

[By] design, [equity]indexed annuities cannot add value through security selection ….[T]he hedging strategies [used by equity-indexed annuities] ensure that the individuals buying equity-indexed annuities will bear essentially all the risks. Consequently, all indexed annuities must (ital) produce risk-adjusted returns that trail those offered by readily available marketable securities by their spread, that is, by their expenses including transaction costs.⁸

Furthermore, by design, indexed annuities typically impose restrictions on the amount of return that an investor can actually receive. Therefore, the combination of the design of these products and the restrictions on returns typically imposed by EIAs/FIAs ensure a fiduciary breach.

So, even though the annuity industry markets these equity indexed annuities by emphasizing stock market returns, the majority of fixed indexed annuity owners are guaranteed to never receive the actual returns of the stock market. While some annuity firms are marketing so-called “uncapped” equity indexed annuities, they may still impose restrictions, and such “uncapped” returns…come with additional costs.

The restrictions and conditions that equity indexed annuities naturally vary. For example, during my time as a compliance director, the equity indexed annuities I saw typically imposed a 8-10 percent cap and a participation rate of 80 percent. What that meant was that regardless of the returns of the applicable market index, with a cap of 10 percent, the most the annuity owner could receive was 10 percent of the index’s return.

As if that was not unfair enough, that 10 percent return was then further reduced by the annuity’s participation rate. So, with a participation rate of 80 percent, the maximum return an investor could receive in our example was 8 percent.

More recently, the point has been made that while a fixed indexed annuity may claim to only impose a certain amount of spread, for instance a 2 percent “spread” that would only reduce the annuity owner’s realized return by 2 percent on a capped return of 10 percent, “humble arithmetic” indicates that the impact of the 2 percent “spread” a capped 10 percent return would be a 20 percent reduction in return (A basis point equals 1/100th of 1 percent, so 100 basis points equals 1 percent. 200 basis points divided by 1000 basis points equals 20 percent).

Reichenstein points out even more inequities, noting that  

Because interest rates and options’ implied volatilities change, the insurance firm almost always retains the right to set at its discretion at least one of the following: participation rate, spread, and cap rate.⁹

And finally, a simple explanation of how equity indexed annuity companies aka indexed fixed annuities further manipulate returns to ensure that they protect their interests first.

From AmerUS Group financial statements, ‘Product spread is a key driver of our business as it measures the difference between the income earned on our invested assets and the rate which we credit to policy owners, with the difference reflected as segment operating income. We actively manage product spreads in response to changes in our investment portfolio yields by adjusting liability crediting rates while considering our competitive strategies….’ This spread ensures that the annuity will offers noncompetitive risk-adjusted returns.¹⁰

I could go on to discuss additional issues such as single entity credit risk and illiquidity risk, but I think investment fiduciaries get the picture. The evidence against equity index annuities establishes that they are a fiduciary breach simply waiting to happen. I strongly recommend that plan sponsors and other investment fiduciaries read Reichenstein’s analysis before deciding to offer fixed indexed annuities, in any shape or form, in their plans or to clients. With no legal obligation to offer annuities of any type, the obvious risk management question is – “why go there?”

3. Variable Annuities
Any fiduciary that sells, uses, or recommends a variable annuity (VA) has probably breached their fiduciary duty…period. Annuity expert Moshe Milevsky summed it up perfectly with the following observations and opinions in his classic article, :The Titanic Option”:

Exhibit A
Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.

[T]he fee [for the death benefit] is included in the so-called Mortality and Expense (M&E) risk charge. The M&E risk charge is a perpetual fee that is deducted from the underlying assets in the VA, above and beyond any fund expenses that would normally be paid for the services of managed money.¹¹

[T]he authors conclude that a simple return of premium death benefit is worth between one to ten basis points, depending on purchase age. In contrast to this number, the insurance industry is charging a median Mortality and Expense risk charge of 115 basis points, although the numbers do vary widely for different companies and policies.¹²

The authors conclude that a typical 50-year-old male (female) who purchases a variable annuity—with a simple return of premium guaranty—should be charged no more than 3.5 (2.0) basis points per year in exchange for this stochastic-maturity put option. In the event of a 5 percent rising-floor guaranty, the fair premium rises to 20 (11) basis points. However, Morningstar indicates that the insurance industry is charging a median M&E risk fee of 115 basis points per year, which is approximately five to ten times the most optimistic estimate of the economic value of the guaranty.¹³ (emphasis added)

Excessive and unnecessary costs violate the fiduciary duty of prudence, especially when they produce a windfall for an annuity issuer at the expense of the annuity owner. The value of a VA’s death benefit is even more questionable given the historic performance of the stock market. As a result, it is unlikely that a VA owner would ever need the death benefit. These two points have resulted in some critics of VAs to claim that a “VA owner needs the death benefit like a duck needs a paddle.”

Exhibit B
Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.

At what cost? VAs often calculate a VAs annual M&E charge/death benefit based on the accumulated value within the VA, even though contractually most VAs limit their legal liability under the death benefit to the VA owner’s actual investment in the VA.

This method of calculating the annual M&E, known as inverse pricing, results in a VA issuer receiving a windfall equal to the difference in the fee collected and the VA issuer’s actual costs of covering their legal liability under the death benefit guarantee.

As mentioned earlier, fiduciary law is a combination of trust, agency and equity law. A basic principle of fiduciary law is that “equity abhors a windfall.” The fact that VA issuers knowingly use the inequitable inverse pricing method to benefit themselves at the VA owner’s expense would presumably result in a fiduciary breach for fiduciaries who recommend, sell or use VAs in their practices or in their pension plans.

The industry is well aware of this inequitable situation. John D. Johns, a CEO of an insurance company, addressed these issues in an article entitled “The Case for Change.”

Another issue is that the cost of these protection features is generally not based on the protection provided by the feature at any given time, but rather linked to the VA’s account value. This means the cost of the feature will increase along with the account value. So over time, as equities appreciate, these asset-based benefit charges may offer declining protection at an increasing cost. This inverse pricing phenomenon seems illogical, and arguably, benefit features structured in this fashion aren’t the most efficient way to provide desired protection to long-term VA holders. When measured in basis points, such fees may not seem to matter much. But over the long term, these charges may have a meaningful impact on an annuity’s performance.¹⁴

In other words, inverse pricing is always a breach of a fiduciary’s duties of both loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without any commensurate return, which would presumably violate Section 205 of the Restatement of Contracts.

Exhibit C
Benefit – VAs allow their owners the opportunity to invest in the stock market and increase their returns.

VAs offer their owners an opportunity to invest in equity-based subaccounts. Subaccounts are essentially mutual funds, usually similar to the same mutual funds that investors can purchase from mutual fund companies in the retail market.

While there has been a trend for VAs to offer cost-efficient index funds as investment options, many VA subaccounts are essentially same overpriced, consistently underperforming, i.e., cost-inefficient, actively managed mutual funds offered in the retail market. As a result, VA owners’ investment returns are typically significantly lower than they would have been when compared to returns of comparable index funds.

Exhibit D
Benefit – VAs provide tax-deferral for owners.

So do IRAs. So do any brokerage account as long as the account is not actively traded. However, dividends and/or capital gain distributions are taxed when they occur.

The key point here is that IRAs and brokerage accounts usually do not impose the high costs and fees associated with annuities. This is especially true of VAs, where annual fees of 3 percent or more are common, even higher when riders and/or other options are added.

Remember the earlier 1/17 note? Multiply 3 by 17 to see the obvious fiduciary issues regarding the fiduciary duties of loyalty and prudence. 

Although not an issue for plan sponsors, another “at what cost” fiduciary issue for other investment fiduciaries has to do with the adverse tax implications of investing in non-qualified variable annuities (NQVA). Non-qualified variable annuities are essentially those that are not purchased within a tax-deferred account, e.g., a 401(k)/403(b) account, an IRA account.

When investors invest in equity investments, they typically are not taxed on the capital appreciation until such gains are actually realized, such as when they sell the investment or, in the case of mutual funds, when the fund makes a capital gains distribution.

In many cases, investors can reduce any tax liability by taking advantage of the special reduced tax rate for capital gains. However, withdrawals from a NQVA do not qualify for the lower capital gains tax. All withdrawals from a NQVA are considered ordinary income, and thus taxed at a higher rate than capital gains. An investment that increases its owner’s tax liability by converting capital gains into ordinary income is hardly prudent or in an investor’s “best interest.”

Bottom line – there are other less costly investment alternatives available that provide the benefit of tax deferral. While they may not offer the same guaranteed income, they provide other significant benefits, while avoiding some of the fiduciary liability risks associated with VAs, e.g., reduced flexibility, purchasing power risk, higher taxes.

Exhibit E
Benefit: Annuity owners do not pay a sales charge, so more of their money goes to work for them.

The statement that variable annuity owners pay no sales charges, while technically correct, is misleading. Variable annuity salesmen do receive a commission for each variable annuity they sell. Commissions paid on VA sales are typically among the highest paid in the financial services industry.

While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through a variable annuity’s various fees and charges.

To ensure that the cost of commissions paid is recovered, the annuity issuer typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for a specific initial surrender charge during the first year, then decreasing 1 percent each year thereafter until the eighth year, when the surrender charges would end. There are some surrender charge schedules that charge a flat rate over the entire surrender charge period.

Going Forward
I have been asked by clients and the media for my opinion on what I see for fiduciary law and 401(k) litigation going forward. My answer-a significant increase in litigation.

What too many plan sponsors fail to recognize and appreciate is the fact that those recommending the inclusion of annuities in plans generally are not doing so in a fiduciary capacity and therefore arguably have no potential fiduciary liability. Plan sponsors, trustees and other investment fiduciaries that follow such advice will typically have unlimited personal liability exposure based on the issues discussed herein.

Plan sponsors and other investment fiduciaries have a duty to independently investigate, evaluate, select and monitor the investment options they select or recommend.

• 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.¹⁵
• 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.¹⁶ 
• 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.¹⁷

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.¹⁸ 

These fiduciaries duties are inviolate. There are no “mulligans” or “do overs” in fiduciary law. As the courts have repeatedly pointed out, “A pure heart and an empty head’ are no defense to allegations of the breach of one’s fiduciary duties.¹⁹

If anything positive comes out of the current debate over the inclusion of annuities in 401(k) plans, hopefully it will be a greater recognition and appreciation of the importance of one’s fiduciary duties by plan sponsors and other investment fiduciaries.

Plan sponsors and other investment fiduciaries considering offering/recommending annuities, in any form, need to always remember some basic rules of fiduciary law:

1. There are no “mulligans” or “do-overs” in fiduciary law.
2. There is no balancing of good versus bad features/acts in fiduciary accounts. Fiduciary errors are strictly “one and done.”
3. Courts in fiduciary cases often admonish defendant fiduciaries that “a pure heart and an empty head” are no defense to claims of a fiduciary breach. Smart fiduciaries do not voluntarily assume unnecessary fiduciary liability exposure.

In my practice as a fiduciary risk management consultant, I focus on two basic principles emphasized in Section 90 of the Restatement: cost-consciousness/cost-efficiency and commensurate return. Three comments within Section 90 of the Restatement, commonly known as the “Prudent Investor Rule,” provide a simple blueprint for selecting prudent investment options for ERISA plans.

• Comment b states that “cost-conscious management is fundamental to prudence in the investment function.”
• Comment f states that ”A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.”
• Comment h(2) essentially says that actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent.

As the exhibits provided herein show, annuities typically fail on all three points due to excessive fees and failure to provide a commensurate return. Add in the fact that plan sponsors have no obligation, legal or otherwise, to provide annuities or any type of “guaranteed income” product. Common sense, as well as the lack of any legal requirement to offer such products, dictate that a prudent plan sponsor will avoid these products altogether given the inherent liability issues in such products. A prudent plan sponsor will allow a plan participant interested in such products to purchase them outside of the plan, thereby avoiding any potential liability exposure for the plan sponsor.

Resources
The article by Frank, Mitchell, and Pfau provides detailed instructions on how to perform annuity breakeven analyses using Microsoft Excel.

Notes
1. Meinhard v. Salmon, 249 N.Y. 458, 464 (1928).
2. 29 CFR 2509.2015-01.
3. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”). http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”), http://www.gao.gov/new.item/d0721.pdf
4. Peter C. Katt, “The Good, Bad, and Ugly of Annuities,” AAII Journal, November 2006, 34-39
5.  Jeremy Babener, “Justifying the Structured Settlement Tax Subsidy: The Use of Lump Sum Settlement Monies,” NYU Journal of Law & Business (Fall 2009), 36.
6. Larry R. Frank, Sr., John B. Mitchell, and Wade Pfau, “Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios,” Journal of Financial Planning, April 2014, 38-7.
7. Reichenstein, 302.
8. Reichenstein, 303.
9. Reichenstein, 309.
10. Reichenstein, 309..
11. Moshe Miklevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126, 92. (Milevsky and Posner)
12. Milevsky and Posner, 94.
13. Milevsky and Posner, 122.
14. John D. Johns, “The Case for Change,” Financial Planning, September 2004, 158-168.
15. 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).
16. Liss v. Smith, 991F.Supp. 278 (S.D.N.Y. 1998).
17. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003). (Gregg)
18. Gregg, 842.
19. Cunningham, 1461.

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