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

During a recent deposition I asked the plan sponsor if he understood the requirement under the fiduciary duties of prudence and loyalty. His answers were your basic ERISA 404(a) language. When he finished describing the duty of loyalty, I clearly surprised him when I asked, “Anything else?”

I have recently posted a number of posts about my expectation of the coming increase in fiduciary litigation involving RIAs and annuities based on their breach of their fiduciary duty of loyalty. When I inform plan sponsors, RIAs, and other investment fiduciaries that the duty of loyalty includes a duty to disclose all material facts that they knew or should have known.¹ The same “should have known” language shown in ERISA 404(a).

“Of course, the thoroughness of a fiduciary’s investigation is measured not only by the actions it took in performing it, but by the facts that an adequate evaluation would have uncovered.² (Scalia, J., concurring in part and dissenting in part)

[T]he determination of whether an investment was objectively prudent is made on the basis of what the trustee knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate.” (emphasis in original))^.3

blind reliance on a broker whose livelihood was derived from the commissions he was able to garner — is the antithesis of such independent investigation. ⁴

If a plan sponsor RIA, or other investment fiduciary is not even aware of the duty of disclosure required under ERISA the duty of loyalty, as set out in section 78(3), it is reasonable to assume that the required investigation and evaluation, as well as the required disclosure of material facts, was not performed as well. Given the annuity industry’s known opposition to transparency and disclosure, that assumption is more reasonable since it was unlikely that the annuity issuer did or would provide material information such as applicable spreads and other costs. or the risks involved with a particaular type of annuity.

So, what constitutes “material information” that must be disclosed under the fiduciary duty of loyalty, as set out in Section 78(3)?

Information is ‘material’ if there is a substantial likelihood that, the disclosue of the omitted fact would have been viewed by the reasoanble investor as having significantly altered the ‘total mix’ of information made available.⁵

I am a big fan of Stanford University’s new AI platform, STORM (storm.genie,stanford.edu. I especially like the fact that STORM includes extensive footnotes, which helps in further researching, as well as a BrainSTORMing section, which provides focused answers from various experts on issues relevant to the original topic

I submitted a “material information” query to STORM. I cannot improve on the answer it provided:
/quote

“Under ERISA, the term “material” refers to any information that could affect a participant’s decision-making regarding their investments. This inlcudes details about the investment options available , the associated risks an returns, and any fees that might be incurred. The requirement emphasizes that participants mu be able to understand the risk and benefits of each option, allowing them to make choicds that align with their financial goals and risk tolerance^.6

The Department of Labor (DOL) has issued guidelines specifying the type of information that must be disclosed, which encompasses investment performance data, fee structures, and the nature of the risks associated with each investment option. Effective communication of the information is crucial for ensuring that participants can exercise informed control over their accounts and make prudent investment choices. ⁷

Fiduciaries must carefully navigate the complexities of compliance with the sufficient information requirement. Failure to adequately disclose material information can expose them to legal challenges from participants, as it undermines the intended protective mechanisms of ERISA^.8

[Restatement Section 78(3) and ERISA Section (404(a) emphasize] the fiduciary duty of plan administrators to provide necessary disclosures oin a manner that allows participants to make informed investment decisions.^“9

The annuity indusry has been engaged in a campaign to convince RIAs and plan sponsors to increase their use of annuities. My concern is that in the annuity industry’s marketing materials on so-called “advisory annuities,” they have tended to focus on the compensation issue, suggesting that fiduciaries can use “advisory annuities” to increase income while avoiding legal hassles, since advisory annuities do not pay a commission. Fiduciaries cannot receive commissions or other financial compensation from third parties, as it would create conflict of interest issues. However, the compensation is far from being the only liability issues investment fiduciaries have to consider in connection with annuities.

For example, most of the annuity industry annuity marketing material to RIAs that I have seen seems to suggest that RIAs can recommend annuities to their clients, even if the client does not understand annuities, and then turn around and offer to manage the annuity for them, using management fees to make up for the loss of commissions. In the retail securities industry, this is known as “double dipping” and is prohibited. While I understand the managing variable annuities concept, no annuity advocate has explained the concept of managing FIAs, given the structure of the product and the fact that the FIA issuer typically reserves the right to unilaterally change key terms within the FIA annually to protect the issuer’s best interests

In a famous study by annuity expert, Moshe Milevsky, Milevsky determined that variable annuities were charging five to ten times the industry’s median M&E risk fee of 115 basis points (1.15%) a year, a fee five to ten the most optimistic estimate of the economic benefit of the death benefit guarantee.This raises obvious fiduciary breach issues.¹⁰ In my opinion, inverse pricing is a blatant breach of an investment fiduciary’s fiduciary duties.

Insurance/annuity executive John D. Johns wrote an article in which he suggested it was time for change, as inverse pricing was counterintuitive.

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.¹¹

As mentioned earlier, my concern is that the annuity industry’s marketing materials to RIAs on advisory annuities that I have seen could be deemed misleading and could expose RIAs to fiduciary liability unless they consider the other potential fiduciary liability issues, e.g., cost of death benefit, inverse pricing, and cost inefficiency of the subaccount offered by a variable annuity. Trying to discuss these issues with annuity advocates has proven to be extremely difficult in most cases, with such irresponsible statements such as “you cannot be a fiduciary unless you offer annuities.” Tell me you know nothing about fiduciary law without telling me that you know nothing about fiduciary law.

An example of inverse pricing would be where the annuity contract limits the death benefit to the annuity owner’s actual capital contribution. So, if the variable annuity (VA) owner’s actual contribution was only $100,000, his death benefit would be limited to $100,000. With inverse pricing, the annuity issuer typically uses the accumulated value of the VA instead of the contract’s terms. As a result, if the VA has grown to $200,000, under inverse pricing, the annuity issuer charges an annual fee based on the $200.000 accumulated value instread of the actual amount under the terms of the annuity contract. Counterintuitive indeed. Pay more to get less.

My experience has been that annuity brokers do not disclose if inverse pricing will be used in connection with the VA or explain the risdks and equitable issues involved with inverse pricing. This would appear to be a clear fiduciary breach under Restatement Section 78(3).

As for cost-efficiency of a VA’s subaccounts, I have never seen a case where the plan sponsor, RIA, or other investment fiduciary says that each subaccount was compared to a comparable index fund to determine the cost-efficiency of the VA subaccounts. I believe a case can be made that such information would consitute “material information” under 78(3) and the fiduciary duty to perform an independent investigation and evaluation of each investment option, as well as offering cost-inefficient subaccounts is clearly not in the best interests of a plan participant or RIA client.

During my time as a compliance director, first as an RIA compliance director, then as a general securities compliance director, the brokers all wanted to be approved to exercise discretion so they could offer to manage annuities for a fee, providing for a steady sourve of annual income rather than look for new customer s each year.

FIAs Why Go There At All
In a recent opinion involving the Retirement Security Rule , Chief Judge Barbara M.G. Lynn summed up the fiduciary issues with FIAs, stating that
/quote

The DOL described the complexity of FIAs (fixed indexed annuities) in its Regulatory Impact Analysis (“RIA”). The RIA explained that FIAs generally provide “crediting for interest based on changes in a market index,” but noted there are hundreds of indexed annuity products, thousands of index annuity strategies, and that “the selection of the crediting index or indices is an important and often complex decision.” Further, there are several methods for determining changes in the index, with different methods resulting in varying rates of return. Rates of return are also affected by “participation rates, cap rates, and the rules regarding interest compounding.” Because “insurers generally reserve rights to change participation rates, interest caps, and fees,” FIAs can “effectively transfer investment risks from insurers to investors.” The DOL found that FIAs may offer guaranteed living benefits, but such benefits “may come at an extra cost and, because of their variability and complexity, may not be fully understood by the consumer.” The DOL also cited the SEC, which recently stated, “[y]ou can lose money buying an indexed annuity … even with a specified minimum value from the insurance company, it can take several years for an investment in an indexed annuity to break even.¹ (emphasis added)¹²

Purchasing an annuity, or any investment for that matter, that allows the issuer to annually change the interest rate to be credited and/or other key terms of the investment unilaterally, to effectively shift all investment risk to an investor, makes absolutely no sense. Talk about being counterintuitive.

As Judge Lynn pointed out, FIAs allow the FIA issuer to shift the total risk of loss to the annuity owner.This, on top of the fact that it is unlikely that the annuity issuer has disclosed the spreads that will be used to further reduce the annuity owner’s realized return, is a fiduciary breach action waiting to happen. Any argument suggesting that FIAs are in the best interest of the FIA owner is simply disingenuous and an attempt to justify a fiduciary breach. This is clearly information that would qualify as “material information, as it would definitely impact an investor’s decision in deciding on whether to invest in an FIA.

When it comes to FIAs, the question is why go there at all. Neither ERISA nor any other law requires plans to offer annuities of any type. Academic studies claim plan participants want the income that annuities provide. From a fiduciary risk managment perspective, the plan sponsor’s response should be “so what. ” An investment fiduciary in under no obligation to expose themselves to unnecessary fiduciary risk. Furthermore, plan participants interested in annuities can always purchase annuities outside of the plan, without exposing the plan sponsor to fiduciary risk.

The most obvious and effective risk management strategy is to totally avoid risk whenever possible. Toward that goal, I teach my fiduciary risk management clients a simple two-question process.

(1) Does ERISA or any other law explicitly require you to offer the investment option? ERISA does not explicitly reuuie a plan to offer specific type of investment. Therfore, under current law, the answer to question will always be “no.”

(2) If the answer to question number (1) is “no,” could offering the investment in question possibly expose the plan to unnecessary fiduciary liability?

Since we already know that the answer to the first question is “no,” we can focus purely on the fiduciary risk management issues presented by the second question, what I refer to a the “why go there” issues. Academic studies often argue the interest in annuities from plan participants and the alleged benefits of increased retirement income. From a fiduciary risk mangement perspective, since there is no legal requirement that fiduciaries expose themselves to unnecessary fiduciary risk, a decison to do so would clearly be imprudent. What the academics conveniently refuse to to addess is that a plan participant can easily purchase an annuity outside of the plan, without exposing the plan to unnecessary risk exposure. Why do academics and annuity advocates fail to address the annuity options out of the plan? My theory is that they do not discuss the availability of annuities outside of a plan for the same reason that the annuity industry has targeteted in-plan annuties.

The annuity industry desperately wants greater access to the significant sums in 401(k) plans and other retirement accounts. However, the fact is that annuities, especially guaranteed lifetime income annuities, in their presenrt form, are the antithesis of both fiduciary prudence and fiduciary loyalty. Unless and until the annuity industry acknowledges and properly addesses the legitimate fiduciary liability issues with annuities, in their current form, investment fiduciaries should ignore annuities altogether, especially guaranteed lifetime income annuities.

As for FIAs, simple common sense indicates that FIAs are not a prudent fidiciary investment choice for a number of reasons. First, explain the prudence of investing in a product where the issuer reserves the right to unilaterally change the annuity interest rate and other key terms annually, to effectively shift the entire burden of risk from the insurer to the investor. This simply ensures that the annuity issuer can protect their best interest instead of the annuity owners, a clear breach of fiduciary duties. Secondly, as Judge Lynn pointed out, it allows the annuity issuer to shift all of the risk from the insurer to to the FIA owner. But I’m sure the annuity issuer disclosed all of those risk consideration when they made the required disclosures pursuant to their fiduciary duty of loyalty under 78(3).

An even more basic question is whether FIAs are an inherent breach of a plan’s fiduciary duty of prudence. There is ample evidence that suggests that the structure of FIAs prevents FIAs from being a prudent investment choice. William Reichenstein, a chaired finance professor at Baylor University, has done extensive research on the fiduciary issues associated with FIAs..His conclusion

Because of their design, managers of indexed annuities cannot add value through security selection, they buy Treasury securities and index options, but do not engage in in indovidual security selection….By design, the IA wil produce returns that trail benchmark portfolio by the average spread. ¹³

For the indexed annuities, the question is whether they offer competitive risk-adjusted returns. On average, their returns must trail those of the risk-appropriate benchmark portfolio of Treasurys and index funds[s} by their annual expense. Since by design, indexed annuities cannot add value through security selection, all indexed annuities must produce risk-adjusted returns that trail those avaialble on the risk-appropriate portfolio. Their structure ensures this outcome.¹⁴

Further support for this conclusion is provided by a Mass Mutual study when EIAs, nka FIAs, were first introduced. Mass Mutual’s findings –

“over a 30 year period ending December 2003. the equity-indexed annuity would have delivered just 5.8 percent a year, far below the 8.5 perent for the S&P 500 without dividends and 12.2 percent for the S&P 500 with dividends, reinvested. Indeed, annuity investors would have been better of in super-safe Treasury bills,which delivered 6.4 percent a year.¹⁵

When one considers the various costs and return restrictions imposed by FIAs, a common sentiment among objective observers seems to be expressed by an article entitled “Equity Indexed Annuities: Downside Protection, But at What Cost?”

Each EIA (equity-indexed annuity) has so many moving parts that are under the discretion of the issuing insurer that it is difficult to determine whether company A’s EIA strucure is better or worse than company B’s.¹⁶

As a plaintiff’s attorney, my concern is that such issues and risks will not be disclosed to plan participants, as required by the fiduciary duty of disclosure and loyalty. Disclosure and transparency are the annuity industry’s kryptonite, as it would expose the serious fiduciary issues such as arbitrary and excessive costs and the true impact of caps and other articial and self-serving restrictions on an investor’s end returns. Collectively, these issues are why I constantly remind my fiduciary clients to pause and ask themselves – “Why go there?”, which, in the case of annuities, especially guaranteed life income annuities, ultimately leads to a decision of “Don’t go there!”_

My advice on navigating the 78(3) disclosure requirements and the inherent breach of fiduciary duty of loyalty traps – Don’t even try. Without the spread information for an annuity, plan sponsors and other investment fiduciaries set themselves up for a per se fiduciary breach since they cannot properly perform the required independent investigation and evaluation or the disclosure of material information required by ERISA and 78(3). Better to just avoid annuities and FIAs altogether, since not legally required. To quote Jack Welch, “Don’t make the process harder than it is.” If something is neither required by ERISA or some other law or regulation – “Don’t go there!” As I tell my clients, Keep it simple and smart”

Update: After I published this post, I had numerous responses asking me where to find the Restatement, Third, Trusts and/or to publish the exact languauge from Section 78(3). The American Law Institute (ALI) is the publisher of the Restatement, which is protected by copyright law. I had submitted a request to publish the exact language and the ALI has graciously granted permission for me to do so. Section78 (3) states as follows:
/quote

(3) Whether acting in a fiduciary or personal capacity, a trustee has a duty in dealing with a beneficiary to deal fairly and to communiacte to the beneficiary all material facts the trustee knows or should know in connection with the matter. (emphasis added)

Restatement of the Law, Third, Trusts, copyright © 2003-2012 by The American Law Institute. Reproduced with permission. All rights reserved.

Pretty powerful little provision in terms of fiduciary risk management. And yet, based on my experience, very few investment fiduciaries have ever read Sections 77, 78, 90 (aka The Prudent Investor Rule), or 100 of the Restatement. So, further support for following my three-prong annuity investigation/evaluation approach before considering or adding any annuity to a plan.

The courts have consistently stated that costs qualify as “material information.” As mentioned in the post, per the DOL and GAO, over a twenty year period, each additional 1 percent in fees, cost or anything thst reduces an investor’s end return, e.g., spreads, reduces an investor’s end return by approximately 17 percent. A common 2 percent spread would project to a 34 percent loss, more than one-third , of the value of the investor’s account. Still think it’s not important to make the annuity salesman provide written information on spreads and cumulative costs?

Plan sponsors, share this post with your plan’s investment commitee. As leading ERISA attorney, Fred Reish, likes to say, “forewarned is forearmed.”

Notes
1. Restatement Third, Trusts Section 78(3).
2. Fink v. Nat’l Bank and Trust, 772 F.2d 962
3. In re Unisys Sav. Plan Litigation, 74 F.3d 420, 436 (3d. Cir. 1996)
4. Liss v. Smith, 991 F. Supp. 278, 299 (S.D.N.Y. 1998). (Liss), In re Enron Corp. Securities, Derivatives, and ERISA Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003)
2. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983
5. Basic v. Levinson, 108 S. Ct. 978, 983 (1988)
6. STORM IA analysis (STORM)
8. STORM
9. STORM
10. Moshe Milevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Death Benefit in Variable Annuities and Mutual Fund,” Journal of Risk Management and Inssurancce, Vol. 68, No. 1, (2009), 91-126, 92.
11.John D. Johns,”The Case for Change,” Financial Planning, 158-168, 158 (September 2004) (Johns)
12. Chamber of Commerce of the United States, et. al. v Hugler, 231 F. Supp. 3d 152 (N.D. Tex. 2017) (Lynn decision), 187
13. Reichenstein, W. (2009), “Financial Analysis of Equity Indexed Annuities,” Financial Services Review, 18, 291-311, 303 (Reichenstein)
14. Reichenstein, 303
15. Jonathan Clements, “Big Insurers Avoid Equity-Indexed Annuities, Wall Street Journal, (as published in Pittsburgh Post Gazette), January 14, 2006.
16. Collins, P.J., Lam, H., & Stampfi, J. (2009) “Equity indexed annuities: Downside protection, But at What Cost? Journal of Financial Planning,” 22, 48-57.