“Don’t make the process harder than it is.” – Jack Welch, former GE CEO

When I meet with a prospective client, this is what I always tell them. Then I show them how their current plan is exposing them to unnecessary fiduciary liability exposure.

I continue to see posts and comments about how plan participants want annuities and guaranteed income products. When a plan member brings that issue up, my response is “who cares what plan participants want. You shouldn’t.” A plan sponsor’s fiduciary reality is defined by ERISA and the Restatement of Trusts, not by what plan participants allegedly want or what plan advisers and/or consultants may recommend. nor by the transitory and possibly uneducated wishes of plan participants.

Nowhere in ERISA does it mention any duty to provide investment alternatives that plan participants want. Annuity advocates respond with “that’s horrible” and make unfounded claims about moral and ethical duties to offer their imprudent investment products. Note, this is the same industry that deliberately mislead courts for years with claims that they had reports indicating that 95 percent of injured plaintiffs dissipated their injury awards within five years, also known as the annuity industry’s “squandering plaintiff” ruse. All this was done to try to get courts to require that injured victims accept structured settlements involving annuities, even as the annuity industry was misrepresenting the actual value of such settlements.¹

The goal of the annuity industry’s fraud was to convince courts to require that any monetary award given to an injured victim be in the form of a structured settlement involving an annuity. Fortunately, most courts saw through this ruse, especially when the annuity industry was unable to produce the alleged studies supporting their “squandering plaintiff” claims.²

My fear is that we are seeing a repeat performance of these misrepresentations with relation to the annuity industry’s push for inclusion of annuities and “guaranteed income” products in 401(k) and other ERISA pension plans. One of the services that I provide as part of my fiduciary risk management consultant practice is fiduciary oversight services. Whenever income annuities are involved, I prepare a breakeven analysis like I did during my days as a plaintiff’s personal injury attorney facing the defense’s “squandering plaintiff” argument.

Shown below is a breakeven analysis based on a 65 year-old male purchasing an income annuity. A proper annuity breakeven analysis should factor in both present value, to account for the time value of money, and mortality risk, to factor in the odds that the annuity annuity may not survive long enough to recover the principal originally paid to purchase the annuity. My experience has been that most investors agree with Mark Twain’s famous quote – “I am more concerned with the return OF my money than I am the return ON my money.

As the analysis below shows, even if the 65 year-old purchaser in this example beat the odds and lived to be 100, the owner still would not break even. If mortality risk is factored in, the annuity owner would fall woefully short of breaking even, over $30,000 short!

Fortunately, the reports are that most plan sponsors are not falling for the annuity industry’s annuity and “guaranteed income” marketing push. I am always reminded of what the late Peter Katt, a fee-only insurance adviser, used to say about evaluating insurance products – “At what cost?” For additional information about the inherent fiduciary liability issues with annuities and “guaranteed income” products, read my recent post.

Cost-Benefit Analysis
Cost-benefit analysis is commonly used in the business world to assess the viability of a project. Despite the simplicity of cost-benefit analysis, far too many investment fiduciaries, including plan sponsors, do not employ the strategy, especially given the consistent finding of studies finding that the overwhelming majority of actively managed mutual funds are cost-inefficient, with many not even able to cover their costs2

• 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.³

• 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.⁴

• [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁵

Do costs exceed benefits? How much simpler could fiduciary prudence be for investment fiduciaries. Since studies show that humans are visually oriented, I created a visual metric, the Active Management Value Ratio (AMVR). I teach my clients, as well as investment fiduciaries, attorneys, and investors, how to use the AMVR to quickly calculate the cost-efficiency and fiducairy prudence of an actively managed mutual fund relative to a comparable index fund. The AMVR is based on the research of investment icons, including Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel.

The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.⁶

So, the incremental fees for an actively managed mutual fund realtive to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high – on average, over 100% of incremental returns.⁷

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover.⁸

There are actually two forms of the AMVR, one that uses just a fund’s nominal, or publicly reported performance data, and a second version, which incorporates Miller’s Active Expense Ratio, which allows an attorney or investment fiduciary to detect both a fiduciary breach and the projected resulting monetary damages, using Miller’s Active Expense Ratio. Miller explained the importance of the AER as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark indexs.⁹

The two-column version is based on the funds’ nominal performance data. In this example, a plan sponsor can easily see that the actively managed fund is cost-inefficient, thus imprudent relative to the comparable index fund, since the active fund provides no benefit for the additional/incremental costs. Since studies have shown that most actively managed funds are cost-inefficient relative to comparable index funds, the two-column AMVR is a quick way to evaluate actively managed funds with minimal data requirements.

When questions of potential legal liability are involved, the three-column AMVR is the preferred option since it allows a fiduciary to determine both potential liability exposure and the projected cost of damages from such breach of fiduciary dutiesby incorporating Miller’s AER. In this example, treating the underperformance of the actively managed fund as an opportunity cost, the projected cost would be 4.83 per share (1.95 + 2.88).

Based on the research of both the GAO and the DOL, showing that each additional one percent of costs/fees reduces an investor’s return by approximately 17 percent over 20 year period, the investor would suffer a projected loss of 82 percent of their end-return from the cost-inefficient actively managed fund.¹⁰

Fortunately, the AMVR provides a quick and easy way for a plan sponsor to proactively detect such potential fiduciary breaches using “humble arithmetic,” and to protect their plan participants by ensuring that the investment options offered within the plan are cost-efficient, thus prudent. Fiduciary risk management literally can, and should be that simple.

Going Foward
While there are some other proprietary techniques and strategies that we use to reduce potential fiduciary liability exposure, the strategies discussed here are key parts in our process simplification model which we refer to as our KISS model – Keep It Simple and Smart!

Smart people do not assume unnecessary risk. Going back to the issue of annuities within plans, plan participants desiring annuities or “guaranteed income” products still have the opportunity to purchase those products outside of the plan, allowing the plan sponsor to avoid any liability issues.

Fiduciary liability is all about employing prudent processes in managing ERISA plans. So don’t make the fiduciary process harder than it is.

That said, we always suggest to our clients to insist that their plan adviser provide then with written AMVR analyses on funds and breakeven analyses on annuities using the exact methods shown here. It will make a plan sponsor’s life easier and, if an adviser refuses (and most do), this will let a plan sponsor know to keep looking for a better adviser candidate.

Notes
1. Jeremy Babener, “Justifying the Structured Settlement Tax Subsidy: The Use of Lump Sum Settlement Monies,” NYU Journal of Law & Business (Fall 2009), 36 (Babener); Laura Koenig, “Lies, Damned Lies, and Statistics: Structured Settlements, Factoring, and the Federal Government,” Indiana Law Journal, Vol. 82, Issue 3, Article 6, available at https:www.repository.law.indiana.edu/ilj/vol82/iss3/ 6. (Koenig).
2. Babener, Koenig.
3. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
4. 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. 
5. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
6. William F. Sharpe, “The Arithmetic of Active Investing,” available online t https://web.stanford.edu/~wfsharpe/art/active/active.htm.
7. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
8. Burton G. Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
9. 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.
10. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and 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).

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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.