Less Is More: Plan Sponsors and the Art of Fiduciary Thinking

Posted on March 30, 2022 by jwatkins

When I read about the House passing the SECURE 2.0 bill, I had three immediate thoughts:

  • “Annuities are sold, not bought.”
  • “So, plan sponsors are going to be able to automatically force employees to contribute to non-compliant 401(k) plans loaded with cost-inefficient, legally imprudent actively managed mutual funds.”
  • “It’s a fiduciary trap.”

It’s the third point I want to focus on in this post. SCOTUS recently addressed the impropriety of 401(k) plans combining prudent and imprudent investment options within a plan.

Now, plans are being advised to unilaterally insert defensive clauses into their plans in an effort to reduce 401(k) and 403(k) litigation. Given the fact that such clauses would obviously only benefit the plan, it would seem that such strategies would blatantly violate the plan sponsor’s fiduciary duty of loyalty, the duty to act exclusively in the best interests of the plan participants and their beneficiaries.

As for SECURE 2.0, forcing employees to contribute to a non-compliant ERISA plan raises obvious legal liability questions. As for allowing annuities, in any form, in 401(k) plans, the is indefensible, as will be discussed later.

As a former securities and RIA compliance director, I am well-acquainted with the financial services’ saying-“annuities are sold, not bought”–and the truth behind the saying and reasons for same. The annuities industry has continually attempted to get RIAs and 401(k) plans to embrace their products. Smart investment fiduciaries have refused to fall into the liability trap that annuities pose for fiduciaries.

Fiduciary law is a combination of three types of law–trust, agency and equity. The fundamental 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 and prudence. The two consistent themes throughout the Restatement are cost-efficiency and risk management through diversification.

I am 67, so I remember the famous “Pogo” cartoon strip where Pogo says “we have met the enemy…and he is us!” In far too many instances, that sums up the current fiduciary liability crisis involving plan sponsors. I honestly believe that most plan sponsors have good intentions. The problem is that they continue to listen to the wrong parties and blindly rely on such parties’ advice, even though the courts have consistently stated that such blind reliance on third-party advice is a per se breach of their fiduciary duties.

It is by now black-letter ERISA law that ‘the most basic of ERISA’s investment fiduciary duties [is] the duty to conduct an independent investigation into the merits of a particular investment.’ 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. Liss v. Smith, 991, F. Supp. 278, 297 (S.D.N.Y. 1988)

So, this is not a new requirement that should come as a surprise to 401(k) plan sponsors. In my conversations with plan sponsors during audits and casual conversations, they obviously are aware of the requirement and the consequences for non-compliance. The problem–they consistently admit that they do not know how to perform the required investigation and evaluations.

Plan sponsors are saying that they have never been trained to think like a fiduciary. The obvious question is “why.” Why have plan advisers not taught them how to perform he required fiduciary procedures? Is it to prevent plan sponsors from being able to assess the true value, or lack thereof, of the services that their plan advisor provides? Is it a self-serving strategy by plan advisers to try to justify their high fees with unnecessarily complex and confusing plans?

Whatever the reason, why have plan sponsors not taken the initiative to find someone to teach them what the applicable law is, how to use that law to design a legally compliant decision-making process rather than constantly exposing themselves the unnecessary fiduciary liability/ Trust me, 401(k) litigation is only going to get worse.

I was a PoliSci major in college. However, my minor was psychology, with a concentration in cognitive psychology, the study of decision-making. The human mind continues to fascinate me.

Most people know Annie Duke as a champion poker player. What most people do not known is that Annie has an M.B.A. in cognitive psychology. She now practices as a decision strategist. She has written two excellent books on the decision-making process, “Thinking in Bets” and “How to Decide.” Her third book, “Quit,” comes out this Fall.

Annie’s message is simple and direct: the quality of our lives depends on the quality of our decisions and luck.  In “How We Decide,” Annie discusses the value of quit-to-itiveness, the value of realizing that change is needed and can be a positive move,

When I created the Active Management Value Ratio (AMVR) metric, part of the reasoning was to help teach investment fiduciaries how to avoid unnecessary fiduciary risk by thinking like a fiduciary, how to simplify the fiduciary prudence process. The other part of the reasoning, honestly, was to help fellow ERISA plaintiff attorneys expose ERISA non-compliant 401(k) and 403(b) plans.

I figured attorneys would listen to the rationale behind the metric. They have. I figured that plan sponsors, trustees and other investment fiduciaries would not listen. I was right.

With the Hughes v. Northwestern University decision and the resulting “fiduciary responsibility trinity” of Hughes, Tibble v. Edison International, and Brotherston v. Putnam Investments, LLC, plan sponsors and other investment fiduciaries are clearly at the crossroads, as it is time to “fish or cut bait.” Again, 401(k)/403(b) litigation is not going away. To be honest, the cases are simply too easy to win or settle as long as they are properly plead.

For example, if I were to present this AMVR forensic analysis to you as a plan advisor, what would you decide-prudent or imprudent?

Nobel laureate Dr. William Sharpe has offered the following advice for analyzing the prudence of mutual funds:

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.”

Noted wealth management expert, Charles D. Ellis, goes further, stating that

So, the incremental fees for an actively managed mutual fund relative 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 that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!

So, analyzing the AMVR forensic analysis as a fiduciary using the following guidelines, would you deem the actively managed fund to be prudent or imprudent?

The actively managed fund is clearly an imprudent investment for a fiduciary, or anyone else for that matter, relative to the benchmark used, the Vanguard Large Cap Growth Index Fund (VIGAX). Yet the actively managed fund shown, Fidelity Contrafund Fund, K shares (FCNKX), is consistently in the top five funds in U.S. domestic 401(k) plans. Common sense should indicate that any fund whose incremental costs exceed their incremental return, when cost exceed benefits, is imprudent.

So, what about annuities. I wrote a lengthy post on the issue of variable annuities https://investsense.com/2021/04/21/variable-annuities-reading-between-the-marketing-lines/. The high costs associated with annuities and the potential loss of one’s life’s savings to the annuity issuer rather than one’s heirs are negatives often associated with annuities.

Annuities within 401(k) plans add yet another issue, the possibility that the 401(k) may be forced to annuitize an annuity in order to make the required minimum distributions required on retirement accounts. Once an annuity owner annuitizes the annuity, the annuity issuer, not the annuity owner, owns and controls the funds in the annuity. Some annuities are so determined to get their hands on the funds in an annuity that they force the annuity owner to annuitize at a certain age. 

As Annie would say, annuities are essentially a bet. The annuity company calculates your life expectancy and bases payments accordingly. The annuity is betting that you will die sooner than projected, resulting in a cash “windfall” for them. Same goes if the annuity owner chooses a life/survivor option, in which case the payments to the annuity owner and survivor are reduced to factor in the combined life expectancy. Again, the annuity issuer is betting that the owner and the survivor will die earlier than estimated, leaving a cash “windfall” in the annuity for the issuer, not any heirs.

Whenever I perform a 401(k) fiduciary audit, I talk to the plan sponsor and investment committee to determine just how well they understand their fiduciary duties. In most cases, not very well, if at all. As I mentioned earlier, in most cases they just blindly accept whatever their plan adviser of some other third-party tells them.

“Retirement readiness” is a buzzword often heard in connection with 401(k) and 403(b) plans. Plan sponsors and investment committees often tell me that means they need to ensure the performance of the investment options chosen for their plan. I then explain to them that they simply cannot ensure such results; that their only fiduciary duty is to perform the required independent investigation and evaluation and use a prudent process to select the fund’s investment options.

I always enjoy the reaction when I explain to a plan sponsor and an investment committee just how easy it is to design, implement and maintain an ERISA compliant 401(k)/403(b) plan. Rick Ferri, Chris Tobe and I recently established the “CommonSense 401(k) Project’ for the purpose of explaining just how simple and cost-efficient operating an ERISA compliant 401(k) plan can, and should, be.

Plan sponsors and investment committees are amazed when I explain that ERISA compliant 401(k) plans can be designed with as few as 3-5 prudently selected investment options. No more confusing 20-30 investment option plans, no more “paralysis by analysis.” This generally makes the required fiduciary duty of ongoing monitoring process easier, reduces costs, and potentially increases employee participation due to the simplicity of participating in the plan.

Going Forward
Assuming that SECURE 2.0 becomes law, 401(k) plan sponsors and investment committees face some significant decisions, decisions which could easily expose both the sponsor and investment committee to unnecessary fiduciary liability exposure. To avoid such situations, plan sponsors and investment committees need to learn and understand the applicable laws and learn how to think like investment fiduciaries. By doing so, they can create a win-win 401(k) plans, a situation where “less is more” is actually legally compliant. For further information and to schedule a free consultation, visit https://commonsense401kproject.com

Posted in 401k, 401k compliance, 401k investments, Active Management Value Ratio, Annuities, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary standard, pension plans, prudence | Tagged , , , , , | Leave a comment

Connecting the Dots: Correlation of Returns and Fiduciary Prudence

Posted on March 19, 2022 by jwatkins

With SCOTUS’ recent decision in Hughes v. Northwestern University1, we now have what I like to refer to as the “fiduciary responsibility trinity” (Trinity). The Trinity consists of the Tibble v. Edison International2 (Tibble), Brotherston v. Putnam Investments, LLC3(Brotherston), and Hughes/Northwestern decisions.

I recently reviewed the relevant language from each decision in a post on a sister blog, the “CommonSense 401(k) Project.”4 To summarize:

Hughes/Northwestern ruled that a plan sponsor has a fiduciary duty to ensure that each investment option within a plan is prudent and to remove any that are not.

Tibble recognized the Restatement of Trusts (Restatement) as a legitimate resource in resolving fiduciary issues and ruled that a plan sponsor has an ongoing fiduciary duty to monitor plan investment options for prudence.

Brotherston ruled that comparable index funds can be used for benchmarking purposes, citing Section 100 of the Restatement.

The question that I am constantly asked by plan sponsors and other investment fiduciaries, as well as attorneys, is “so how do I use all this to evaluate the fiduciary prudence of an investment option?” Obviously, my first response is to use InvestSense’s proprietary metric, the Active Management Value RatioTM (AMVR) to evaluate the investment’s cost-efficiency. But I also suggest that they look at the “AER” column and calculate the investment’s incremental costs using that number>

Why? “AER” stands for Ross Miller’s Active Expense Ratio (AER) metric. The AER uses a mutual fund’s r-squared, or correlation of returns, number to calculate a fund’s effective expense ratio. Based on the AER, Miller found that investors in actively managed mutual funds effectively pay expense ratios 400-500 percent higher than the fund’s publicly expense ratio.

So why calculate an actively managed fund’s correlation-adjusted expense ratio? As Miller explains,

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs 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 index.5

Martijn Cremers, creator of the Active Share metric, goes further, stating that actively managed mutual funds are arguably guilty of investment fraud.

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….

Closet indexing raises important legal issues. Such funds are not just poor investments; they promise investors a service that they fail to provide. As such, some closet index funds may also run afoul of federal securities laws.6

And there it is-“closet indexing.” Closet indexing has become an international issue for the very reasons stated above. Closet indexing refers to a situation where a fund charges a high expense ratio, citing the benefits of the fund’s active management. However, the fund shows a high correlation of returns to a much less expensive, comparable index fund with the same, or better, returns.

Financial advisers and actively managed mutual funds do not like to talk about the costs associates with their funds. Research has consistently shown that the overwhelming majority of actively managed are not cost efficient.

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.7
  • 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.8
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.9
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.10

Cost-consciousness, or cost-efficiency is a constant theme throughout the Restatement. Three comments in Section 90, also known as the Prudent Investor Rule, contains three comments that could, and should, define prudence in future ERISA excessive fees/breach of fiduciary duty actions.

  • A fiduciary has a duty to be cost-conscious. (Introductory Section to Section 90)
  • 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. (cmt. f)
  • 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. (cmt. h(2).

Actively managed mutual funds with high r-squared scores relative to comparable, less costly, index funds are potential candidates for “closet index” fund status. While there is not a universally designated r-squared number for “closet fund” status, most people agree that an r-squared number of 90 or above is a indication that a fund is a “closet index,” aka “index hugger” fund. Morningstar uses an even lower r-squared score of 80.

Over the past decade, the overwhelming majority of actively managed U.S. domestic equity funds have shown an r-squared of 90 or above relative to comparable index funds. The fund used in the AMVR forensic analysis shown below had an r-squared score of 98 relative to the benchmark index fund. The analysis is a perfect example of the potential impact of a fund’s high r-squared score on both its effective expense ratio and resulting cost-efficiency.

Closet index status indicates that an investor could achieve the same, in many cases better returns, at a much lower cost. Cost-inefficient investments waste plan participants’ money. As the Uniform Prudent Investor Act states, “Wasting beneficiaries’ money is imprudent.”11

Going Forward
The Hughes/Northwestern and the resulting “fiduciary responsibility trinity” have raised a plan sponsor’s fiduciary’s duty of prudence to an even higher level than before. In assessing the prudence of a plan’s potential or actual investment option, do plan sponsors, for that matter any investment fiduciary, have a duty to address whether a mutual fund qualifies as a “closet index” fund? Should they have such a duty in order to protect plan participants and other beneficiaries given the obvious harm of “closet indexing?” Is factoring in funds’ r-squared scores/correlations of returns the “next big thing” in 401(k) and fiduciary investment prudence litigation?

Notes
1. Hughes v. Northwestern University, 19-1401 (January 24, 2022).
2. Tibble v. Edison International, 135 S. Ct 1823 (2015).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
4. https://commonsense401kproject.com.
5. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
6. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133.
7. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
8. 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. 
9. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
10. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
11. Uniform Prudent Investor Act (UPIA), Section 7 (Introduction).

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, closet index funds, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, pension plans, prudence, wealth management, wealth preservation | Tagged , , , , , , , , , , , | Leave a comment

The “Fiduciary Prudence Trinity”: A Blueprint for Evaluating the Prudence of Fiduciary Investments

Posted on March 17, 2022 by jwatkins

In my last post, I discussed the significance of three ERISA related decisions-Tibble, Hughes/Northwestern and Brotherston. I like to refer to these three cases as the “fiduciary responsibility trinity,” because I believe that, collectively, they will shape the future of 401(k)/403(b) litigation by providing a “blueprint” for both plan sponsors and ERISA attorneys.

The “fiduciary responsibility trinity” provides a macro blueprint for 401(k)/403(b) litigation. The “fiduciary prudence trinity” (Trinity) provides the micro blueprint for 401(k)/403(b) litigation, a means of evaluating the prudence of a plan’s actual investment options.

The cornerstone of my fiduciary compliance consulting practice is InvestSense’s proprietary metric, the Active Management Value Ratio (AMVR). The AMVR evaluates the cost-efficiency of actively managed mutual funds relative to comparable index funds. While many actively managed funds compare their performance to a comparable market index, market indices do not allow for cost-efficiency analyses since indices do not have costs. That is why the AMVR uses comparable index funds, as such funds do have costs similar to actively managed mutual funds.

In Tibble, SCOTUS recognized the Restatement (Third) of Trusts (Restatement) as a valuable resource in addressing fiduciary issues. The fiduciary prudence trinity is based on three key provisions of section 90 of the Restatement, otherwise known as the “Prudent Investor Rule.”

The common law of trusts ‘offers a starting point for analysis of ERISA….’ 1

[R]ather than explicitly enumerating all of the powers and duties of trustees and other fiduciaries, Congress invoked the common law of trusts to define the general scope of their authority and responsibility.”2

Thus, a federal common law based on the traditional common law of has developed and is applied to define the powers and duties of ERISA plan fiduciaries….3

The Prudent Investor Rule contains three comments that could, and should, define prudence in future ERISA excessive fees/breach of fiduciary duty actions.

  • A fiduciary has a duty to be cost-conscious. (Introductory Section to Section 90)
  • 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. (cmt. f)
  • 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. (cmt. h(2).

The AMVR provides a quick and simple means of addressing each of the three points. Fidelity Contrafund and American Funds’ Growth Fund of America are two popular investment options in U.S. defined contributions plans. Based on the AMVR analyses shown below, should plan sponsors reconsider the inclusion of the funds?

In analyzing the results of an AMVR forensic analysis, the two primary questions are:

1. Does the actively managed fund provide a positive incremental return?
2. If so. does the positive incremental return exceed the actively managed fund’s incremental costs?

If the answer to either of the two questions is “no,” then the actively managed fund is imprudent compared to the benchmark index fund. It’s just that simple. Simple subtraction and division.

In the analyses shown above, both Fidelity Contrafund and Fund of America would be deemed imprudent since neither fund produced a positive incremental return relative to the benchmark fund. A plan sponsor, at a minimum, should consider placing such funds on a “watch” list and continue to monitor the funds.

InvestSense bases its analyses on quarterly returns. Obviously, such returns and analyses results are subject to change. The analyses shown above are based on the 5-year returns of each fund, for the period ending December 31, 2021. When InvestSense does a forensic analysis, we provide an analysis for both the most recent 5 and 10-year period in order to assess consistency of performance.

While it was unnecessary in this case to consider the correlation-adjusted incremental costs of either fund, it should be noted that both funds had an r-squared score of 98. Such costs are shown under the AER column, reflecting InvestSense’s use of Ross Miller’s Active Expense Ratio metric. Obviously, had the funds’ AMVR analyses been based on their AER numbers, their level of imprudence would have been even worse.

Going Forward
The 401(k)/403(b) industry has been changed forever, especially with regard to litigation. While ERISA plaintiff attorneys must still make sure their pleadings meet SCOTUS’ plausibility standard, their job has been made seemingly easier with both the Hughes/Northwestern decision and the resulting “fiduciary responsibility trinity.” By following the “blueprint” provided by combining the “fiduciary responsibility trinity” with the “fiduciary prudence trinity,” ERISA attorneys and plan sponsors/plan fiduciaries can properly protect their respective interests.

Notes
1. In re Enron Corp. Securities, Derivatives, and “ERISA” Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003) (Enron).
2. Ibid.
3. Ibid.

© Copyright 2022 InvestSense, LLC. All rights reserved.

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.

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The “Fiduciary Responsibility Trinity”: ERISA Fiduciary Law After the Hughes/Northwestern Decision

Posted on February 25, 2022 by jwatkins

SCOTUS recently announced its much anticipated decision in the case of Hughes v. Northwestern University.1The significance of the decision cannot be overstated, as it dramatically changes the “rules of the game” for 401(k) and 403(b) retirement plans,

Hughes was the last piece of what I am referring to as the “Fiduciary Responsibility Trinity.” The Trinity is composed of three key ERISA related decisions-Tibble v. Edison International2, Brotherston v. Putnam Investments, LLC3, and Hughes. Given the heavy reliance that the Supreme Court and the First Circuit Court of Appeals, as well as the Solicitor General, placed on the common law of trusts, an argument can be made that the logic set out in the trinity decisions is equally applicable to all investment fiduciaries.

So why are the trinity so important? Here are key quotes from each decision.

Tibble:

We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts.4

The Restatement (Third) of Trusts is a restatement of the common law of trusts. So, the Court is recognizing the Restatement as a legitimate resource in addressing fiduciary questions.

Under trust law, a trustee has a continuing duty to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset…. Rather, the trustee must ‘systematic[ally] conside[r] all the investments of the trust at regular intervals’ to ensure that they are appropriate….In short, under trust law, a fiduciary normally has a continuing duty of some kind to monitor investments and
remove imprudent ones.5

Brotherson:

Congress sought to offer beneficiaries, not fiduciaries, more protection than they had at common law.6

[A]ny fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”7

[T]he Restatement specifically identifies as an appropriate comparator for loss calculation purposes ‘return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).’8

In Brotherston, the lower court had ruled that the plan participants’ expert could not calculate alleged damages by comparing actively managed funds within the plan with comparable index funds, the court ruling that that would constitute comparing “apples to oranges.” The First Circuit’s decision effectively discredits the “apples to oranges” argument.

Hughes:

The Seventh Circuit erred in relying on the participants’ ultimate choice over their investments to excuse allegedly imprudent decisions by respondents. In Tibble, this Court explained that, even in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options…. If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty.9

The Seventh Circuit had dismissed the plan participants’ case on the basis of the “menu of options” argument, which said a mixture of both prudent and imprudent investment options within a plans was permissible, as it provided plan participants with more choices. SCOTUS effectively discredited the “menu of options” defense.

Going Forward
Bottom line, the combined impact of the trinity decisions is that cases will now be decided based on their merits, not on legal fictions such as the “apples and oranges” and “menu of options” defenses. This should result in more protection for plan participants in the form of fewer dismissals of 401(k)/403(b) …as long as the attorneys for plan participants properly plead such cases to meet SCOTUS’ plausibility standard for pleading.

Notes
1. Hughes v. Northwestern University, 19-1401 (2022).
2. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018).
4. Tibble, 1828.
5. Tibble, 1828-29.
6. Brotherston, 37
7. Brotherston, 39
8. Brotherston, 31
9. Hughes, Ibid.

Copyright InvestSense, LLC 2022. All rights reserved.

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.

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The #Northwestern403b Decision: What Next For Plan Sponsors?

Posted on January 29, 2022 by jwatkins

This past Monday, SCOTUS issued its much anticipated decision in Hughes v. Northwestern University (#Northwestern403b) The original issue before the Court was whether or not the plan participants had properly plead their case in their complaint. The lower courts had dismissed the case, relying on a concept known as the “menu of options” defense.

The basic argument of the “menu of options” defense has been that plans satisfy their fiduciary duties under ERISA as long they offered a mixture of investment options, even if some of those investment options would be considered imprudent under applicable legal standards.

In a unanimous 8-0 vote, the Court rejected the “menu of options” defense. Justice Sotomayor, writing for the Court, cited the Court’s decision in Tibble v. Edison International1, stating that

The Court of Appeals for the Seventh Circuit held that petitioners’ allegations fail as a matter of law, in part based on the court’s determination that petitioners; preferred type of low-cost investments were available as plan options. In the court’s view, this eliminated any concerns that other plan options were imprudent.

That reasoning was flawed. Such a categorical rule is inconsistent with the context-specific inquiry that ERISA requires and fails to take into account respondents’ duty to monitor all plan investments and remove any imprudent ones.1

The court vacated the 7th Circuit’s decision and remanded the case back to that court for reconsideration of the plan participants’ allegations.

The implications of this decision cannot be overstated. The decision not only impacts the plan participants in this case, but obviously plan participants in other 401(k) and 403(b) plans. It can, and undoubtedly will be, argued that the Court’s decision is equally applicable to all investment fiduciaries, e.g., trustees, since in Tibble, the Court relied heavily on the Restatement (Third) of Trusts (Restatement) and recognized the Restatement as an authoritative reference source in fiduciary actions.

The key question going forward will obviously be how does an investment fiduciary determine the prudence of a plan investment option. Since Justice Sotomayor relied heavily on the Court’s Tibble decision, I will too.

The two constant themes throughout the Restatement are cost-efficiency and effective diversification. I would suggest that Section 90 of the Restatement, more commonly known as the “Prudent Investor Rule,:” provides four criteria that should always be considered in assessing the fiduciary prudence of any investment.

  • The “Introductory Note” to Section 90 states that cost-consciousness is a fundamental duty in connection with prudent investing.2
  • Comment f of Section 90 states that a fiduciary has a duty to seek the highest rate of return for a given level of costs and risk, or, alternatively, the lowest level of cost and risk for a given level of return.3
  • Comment h(2) states that due to the higher costs and risk typically associated with actively managed products/strategies, a fiduciary should only recommend and/or utilize such funds/strategies when it can be objectively estimated that such funds/strategies will provide a commensurate level of return for such additional costs and risks. Comment h(2) is often referred to as the ,“commensurate return” rule.4
  • Comments m authorizes the use of index funds for benchmarking purposes in evaluating the cost-efficiency/prudence of actively managed mutual funds.5

These four comments, collectively, provide a sound framework for creating a legally acceptable fiduciary prudence due diligence process.

The search for fiduciary prudent actively managed mutual funds will be a challenge. Academic research has consistently found that the overwhelming majority of actively managed funds are not cost-inefficient, with conclusions such as

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.6
  • 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.7
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.8
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.9

Several years ago I created a simple metric, the Actively Managed Value Ratio 3.0™ (AMVR), based on the four previously discussed Restatement comments and the conclusions shown above. Using free publicly available information and basic math skills, fiduciaries, investors and attorneys can evaluate the cost-efficiency of an actively managed mutual fund.

The AMVR analysis shown below illustrates just how simple, yet powerful, the AMVR can be. The analysis is of a well-known actively managed fund that is annually cited as being among the top ten funds in U.S. defined contribution plans by “Pensions & Investments.”

The AMVR is essentially the familiar cost/benefit analysis taught in economics classes, with incremental costs and incremental returns being the input variable, incremental costs divided by incremental returns. An AMVR score greater than 1.00 indicates that the actively managed fund’s incremental costs exceed the fund’s incremental returns. Using a basic definition of prudence, i.e., benefits exceed costs, an AMVR score greater than 1.0 would indicate cost-inefficiency, and thus an imprudent investment relative to the benchmark index fund.

Using the example shown above, the obvious challenge for a plan sponsor, or any investment fiduciary, would be how to justify an additional incremental cost of 72 basis points for only an additional incremental return of 5 basis points as a prudent investment decision. It simply is not.

Going Forward
In a recent article, Jaime A. Santos and Christina Hennecken of Goodwin Proctor, LLP, wrote that

Moreover, the Court’s nod to the range of reasonable judgments fiduciaries may make underscores what many plan sponsors and industry groups have consistently argued in defending ERISA suits—there is no one-size-fits-all approach to plan management and fiduciary decisions, which need to be evaluated based on the context in which they were made. Although this decision is unlikely to slow the onslaught of new lawsuits plan sponsors have faced in recent years, it confirms the appropriate pleading standard that should be used to examine these lawsuits and directs courts to consider the range of reasonable judgments a fiduciary may make.10

“Range of reasonable judgements a fiduciary may make” is a phrase that I expect will be commonly referenced in 401(k) litigation going forward. However, as noted in the Tibble decision,

We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ In determining the contours of an ERISA fiduciary’s duty, court often must look to the law of trusts.11

As courts have consistently noted, ERISA is essentially the codification of the Restatement of Trusts, which is simply a restatement of the common law of trusts. That said, based on the evidence set out herein, I would respectfully suggest that there is a one-size-fits-all approach to plan management and fiduciary decisions – cost-efficiency and the “commensurate return” guidelines of Section 90, comment h(2), of the Restatement (Third) of Trusts. Both the law and common sense support such a position.

In counseling plan advisors and investment fiduciaries in general, I find myself coming back to three quotes that set out simple and sound guidelines for making fiduciary decisions.

So, the incremental fees for an actively managed mutual fund relative 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 that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!12

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”13

When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.14

Perhaps the answer is some form of a simple, common sense 401(k) model that truly promotes the best interests of plan participants best interests, while also reducing a plan sponsor’s potential fiduciary liability exposure. Just a thought.

Selah.

Notes
1. Hughes v. Northwestern University, https://www.supremecourt.gov/opinions/21pdf/19-1401_m6io.pdf
2. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
3.. 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.
4. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
5. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
6. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
7. 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.
8. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
9. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
10. https://www.jdsupra.com/legalnews/hughes-et-al-v-northwestern-university-2052029/
11. Tibble v. Edison International, 135 S. Ct. 1823 (2015). https://www.supremecourt.gov/opinions/14pdf/13-550_97be.pdf.
12. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
13. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
14. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law(1976). (Faculty Scholarship Series: Paper 498) available online at http://digitalcommons.law.yale.edu/fss_papers/498.

© Copyright 2022 InvestSense, LLC. All rights reserved.

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.

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, best interest, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, investments, wealth management, wealth preservation | Tagged , , , , , , , , , , , , | Leave a comment

4Q 2021 AMVR “Cheat Sheet”

Posted on January 3, 2022 by jwatkins

At the end of each calendar quarter, InvestSense publishes the 5 and 10-year Active Management Value Ratio (AMVR) scores of the non-index funds in “Pensions & Investments” annual survey of the most used mutual funds in U.S. defined contribution plans. Currently there are six such funds.

One of the interesting things about the 2021 survey is the continued growth of investments in index funds. The P&I survey ranks funds based on amount of assets invested in each fund, not the actual performance of the fund. The #1 fund overall is the Fidelity S&P 500 Index Fund. The fund is far and away the leader, holding almost 80% more DC assets than the #2 ranked fund.

The AMVR calculates the cost-efficiency of an actively managed mutual fund relative to a comparable index fund. Section 90 of the Restatement (Third) of Trusts emphasizes the importance of cost-efficicency. In announcing the adoption of the Securities and Exchange Commission’s new Regulation Beast Interest, former SEC Chairman Jay Clayton noted the importance of cost-efficiency, stating that

A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes expected utility.

The AMVR is essentially the basic cost/benefit analysis taught in economic classes, with a fund’s incremental costs and its incremental return as the input values (incremental costs/incremental returns). An AMVR score greater than 1.0 indicates that the actively managed fund is cost-inefficient, as its incremental costs exceed its incremental returns.

Since the six funds funds currently in=the “cheat sheets” are all large cap funds, we use three Vanguard index funds (VIGAX, VFIAX and VVIAX) for benchmarking. While some people use nominal costs and nominal returns, sucb data can often be misleading. For that reason, InvestSense calculates AMVR scores using an actively managed fund’s incremental correlation-adjusted costs (ICAC) and incremental risk-adjusted returns (IRAR).

The impact of a fund’s r-squared, or correlation, number is gaining greater recognition as issues such as “closet indexing” receive increased attention. InvestSense uses Miller’ Active Expense Ratio in computing a fund’s (ICAC). As Miller explained,

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs 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 index.

So, with that background, the new 4Q AMVR cheat sheets are shown below:

Two key numbers to look for in using the AMVR is a fund’s r-squared/correlation number and its expense ratio. As you look at the two charts, you can see how dramatically the combination of a high r-squared number and a high expense impacts a fund’s overall cost-efficiency. This is the main reason InvestSense uses incremental correlation-adjusted costs instead of nominal costs, to get a truer evaluation of a fund’s cost-efficiency.

In analyzing the data, the two key questions are:

1. Did the actively-managed fund provide a positive incremental return?
2. If so, did the fund’s incremental return exceed the fund’s incremental costs?

If the answer to either of these questions is “no,” the actively-managed fund is not cost-efficient, and an imprudent investment choice, relative to the benchmark fund.

As to the 5-year AMVR chart, using the ICAC/AER and IRAR data, none of the six fund’s would be prudent relative to the benchmark.

As to the 10-year AMVR chart, using the ICAC/AER and IRAR data, only the Vanguard PRIMECAP Fund’s Admiral shares would be prudent relative to the benchmark, here the Admiral shares of Vanguard’s S&P 500 Fund.

Two funds deserve particular mention. The significant difference in Dodge& Cos Stock Fund’s return data is due to the fact that they had a relatively high standard deviation (19+). The T. Rowe Price Blue Chip Growth Fund usually produces relatively good returns, but the fund’s unusually high expense ratio negates such performance, especially when the fund’s r-squared number is considered.

Some people have told me that the concept of the AMVR and its calculation process are easier to understand by reviewing some of my PowerPoint presentations and the worksheet examples. Those are available at https://www.slideshare.net. Search under “Active Management Value Ratio” to view all of the available presentations.

© Copyright 2022 InvestSense, LLC. All rights reserved.

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.

Posted in 401k, 401k compliance, 401k investments, 403b, cost-efficiency, fiduciary compliance, fiduciary duty, fiduciary liability, Fiduciary prudence, fiduciary prudence, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , | Leave a comment

Plan Sponsor Alert: The Hidden Message in the #Northwestern403b Hearing

Posted on December 18, 2021 by jwatkins

There were two issues properly before SCOTUS in the recent #Northwestern403b hearing: (1) the sufficiency of the plan participants’ complaint, and (2) the legal merits of the 7th Circuit’s rationale for dismissing the plan participants’ complaint, the “menu of options” defense. While no one knows how SCOTUS will decide the first question, there would seem to be no question as to the Court’s decision as the second question given Justice Kagan’s questioning and the very language of ERISA Section 404(a) itself.

I believe that Justice Kagan’s discrediting of the “menu of options” defense, combined with the 1st Circuit’s discrediting of the “apples and oranges” defense based upon comment m of Section 90 of the Restatement (Third) of Trust’s, should send a clear message to plan sponsors and and investment fiduciaries-choose your advisers well!

Pension plans that were advised to rely on the 7th Circuit’s “menu of options” defense now find themselves in what the legal profession calls a “SNAFU,” or a real mess. That”mess” has been the leading topic in my conversations with plan sponsors and legal colleagues since the #Northwestern403b hearing.

Plan sponsors now face having to immediately adjust plan investment options in their plans to remove any that are legally imprudent. Even then, they still face potential liability exposure for any losses attributable to fact that those funds were even offered by the plan.

One would guess that plan sponsors will attempt to rely on “reasonable reliance” on plan advisers and other experts to avoid liability. The first issue is the fact that many plan advisers routinely include fiduciary disclaimer clauses in their advisory contracts. While the Supreme Court has ruled that plan advisers can be sued by plan sponsors in certain circumstances under the common law for claims such as negligence, fraud and breach of contract, that remedy will not defeat a breach of fiduciary duties claim against a plan sponsor.

A “reasonable reliance” defense by plan sponsors faces other formidable hurdles as well. Those hurdles have been described in a number of judicial decisions. Some examples include

  • “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.” 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)
  • “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.” Liss v. Smith, 991F.Supp. 278 (S.D.N.Y. 1998)
  • “While a plan sponsor may hire an adviser or other expert, [t]he fiduciary must (1) ‘investigate the expert’s qualifications’;  (2) ‘provide the expert with complete and accurate information’;  and (3) ‘make certain that reliance on the expert’s advice is reasonably justified under the circumstances.'”

“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.” (emphasis added)

“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. ” Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003)

  • “In determining compliance with ERISA’s prudent man standard, courts objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions.”

    “[F]iduciaries in other circumstances, are entitled to rely on the advice they obtain from independent experts. Those fiduciaries may not, however, rely blindly on that advice.” Bussian v. RJR Nabisco, Inc., 223 F.3d 286, 298-300 (5th Cir. 2000)

Based upon my experience, very few plan sponsors perform, or even know to perform, a through, independent and impartial investigation of the investment options offered by their. Once again, based on my experience, even more troubling is the fact that very few plan sponsors know how to determine if the advisers and experts they choose can, or have, conducted a through, independent and impartial investigation of the investment options offered by a plan.

Perhaps the largest hurdle for plan sponsors attempting to rely on a “reasonable reliance” defense is their “blind reliance”on such third parties. Despite the warning that plan sponsors cannot blindly rely on the advice of third parties, my experience has been that is exactly what most plan sponsors, since their decision to hire an adviser is based on their inability to perform such duties. However, all is not lost for plan sponsors, as such blind reliance, would not defeat the previously mentioned common civil action against a plan adviser.

For those plan sponsors wanting a quick primer on fiduciary compliance under ERISA, the Bussian decision is recommended reading. For those a more detailed discussion of fiduciary compliance under, the lengthy Enron decision is excellent.

For plan sponsors wanting to know about a simple tool that can help them in performing the legally required independent investigation and analysis, I, humbly, recommend InvestSense’s free proprietary metric, the Active Management Value Ratio (AMVR). The AMVR allows fiduciaries, investors and attorneys to easily and quickly assess the cost-efficiency and prudence of an actively managed mutual fund.

In closing, as I always tell my fiduciary compliance clients, “there are no mulligans in fiduciary law.” For that reason, hopefully plan sponsors will take away the hidden message from the #Northwestern403b case-choose your advisers carefully and learn the rules and limitations regarding the use of their advice.

 

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, AMVR, cost consciousness, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary responsibility, fiduciary standard, investment advisers, investments, pension plans, prudence, wealth management, wealth preservation | Tagged , , , , , , , , | Leave a comment

The Really Smart Experts Measure AMVR: Blueprint for 401(k)/403(b) Litigation and Design

Posted on November 26, 2021 by jwatkins

In a recent post, I wrote (1) that plan participants should never lose a properly vetted 401(k)/403(b) litigation action, and (2) a properly designed and maintained 401(k)/403(b) plan should should never lose a breach of fiduciary duties action based on imprudent investment options. As anticipated, the statements drew some strong responses. The most frequent responses focused on “properly vetted” and “properly designed and maintained.”

In my practice, I serve as a fiduciary compliance counsel to both attorneys and 401(k)/403(b) plans. I believe the blueprint for fiduciary compliance for both sides already exists. To help my clients remember the blueprint, I tell them to remember the phrase, “The Really Smart Experts Measure AMVR.”

Studies have shown that people often remember information by using acronyms, with each letter representing an important fact. While the phrase I suggest is not technically an acronym due to AMVR at the end, the phrase serves the same purpose.

1. “The” – “T” stands for the Supreme Court case of Tibble v. Edison International.1 The key quote for our purpose is the Court’s statement that.

We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ In determining the contours of an ERISA fiduciary’s duty, court often must look to the law of trusts.1

2. “Really” – The “R” stands for the Restatement (Third) of Trusts. One of the key concepts throughout the Restatement is the importance of costs and cost-consciousness. Section 90 of the Restatement is commonly known as the Prudent Investor Rule. Comment b states that

[C]ost-conscious management is fundamental to prudence in the investment function,…2

Comments f, h(2) and m also reference the importance of cost-efficiency.

3. “Smart” – The “S” stands for Nobel laureate Dr. William F, Sharpe. Dr. Sharpe stated that in assessing the prudence of actively managed mutual funds,

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.”3

4. “Experts” – The “E” stands for Charles D. Ellis. A well-known and highly respected expert on investing, Ellis suggested the following technique in assessing the prudence of actively managed funds.

So, the incremental fees for an actively managed mutual fund relative 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 that the incremental fees for active management are really, really high—on average, over 100% of incremental returns! 4

5. “Measure” – The “M” stands for Ross Miller, the creator of the Active Expense Metric (AER).

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs 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 index.5

Miller recognized that given the current high R-squared/correlation of returns between actively managed U.S. domestic equity mutual funds and comparable index funds, most of the returns on actively managed can be properly attributed to underlying market indices rather than the active funds’ management teams. As a result, investors can receive comparable, in many cases better, returns at a much lower price using comparable index funds. As a result, the implicit costs that investors are paying for actively managed mutual funds are significantly higher than the funds’ stated expenses. Miller found that the implicit costs of an actively managed fund were often 4-6 times higher than their stated costs.

The Active Management Value RatioTM
All of these are fundamental concepts that form the foundation for the Active Management Value Ratio metric (AMVR). The AMVR is essentially nothing more that the well-known cost-benefit metric often used in the business world. The only difference is that AMVR uses incremental cost and incremental returns as the input data. More specifically, the AMVR compares an actively managed fund’s risk-adjusted incremental returns with the fund’s correlation-adjusted incremental costs, using a comparable index fund as a benchmark.

By using nothing more than “simple third grade math,” the AMVR provides a simple, yet powerful, analysis of an actively managed fund’s cost-efficiency relative to the comparable index fund benchmark. Back when I was developing the AMVR, I was introduced to a brilliant man, Bert Carmody, by some mutual friends. Bert quickly understood the concepts involved in the AMVR and decided to create a more sophisticated model.

My favorite memory of that day was Bert starting to write on the expensive white knapkins and the people next to us laughing as I quickly told Bert that I was not paying for the knapkins. Unfortunately, Bert passed away shortly after that infamous lunch. However, his friends continued his work, resulting in the patented PlanAnalyzer metric. Both metrics are being successfully used in both the legal and financial fields.

The AMVR addresses a simple question that every question should know.

Does the actively managed fund provide a commensurate return for the additional costs and risks an investor is asked to assume?

To answer that question, an investor and/or investment fiduciary simply has to answer two simple questions:

  1. Does the actively managed fund provide a positive incremental return relative to a comparable index fund?
  2. If so, does the actively managed fund’s positive incremental return exceed the actively managed fund’s incremental costs?

If the answer to either of these questions is “no,” then the actively managed fund is not a prudent investment choice relative to the benchmark index fund. The goal is an AMVR score that is greater than zero (indicating a positive incremental return), but less than one (indicating that incremental returns exceed incremental costs). As far as the actual formula for the AMVR,

AMVRTM = Incremental Correlation-Adjusted Costs/Incremental Risk-Adjusted Returns

To illustrate the value and power of the AMVR in assessing cost-efficiency, let’s look at a well-known actively managed fund. In the first example, we will calculate cost-efficiency of the actively managed fund using both funds’ nominal returns and costs.

The chart shows that while the actively-managed fund does produce a small positive incremental return, the fund’s incremental costs significantly exceed the fund’s positive incremental return. Therefore, the actively-managed fund is deemed cost-inefficient relative to the benchmark fund. In this case, the actively-managed fund is classified as the retirement shares of a large cap growth fund. Therefore, the benchmark used in this example is the Admiral shares of Vanguard’s Large Cap Growth fund.

Because of the clients InvestSense serves, we calculate a fund’s AMVR based on risk-adjusted returns and AER-based correlation-adjusted costs. Note the dramatic increase in the actively-managed fund’s expense ratio (0.65) when the fund’s R-squared/correlation of returns number, in this case 98, is factored into the equation (5.44). The combination of high incremental costs and a high R-squared number basically ensures that a mutual fund will not be considered cost-efficient.

At the end of each calendar quarter, I prepare a “cheat sheet” on some of the more commonly used mutual funds in U.S. 401(k) plans. The five-year “cheat sheet for the 3Q of 2021 is shown below.

https://fiduciaryinvestsense.com/wp-content/uploads/2021/10/3q-2021-5y-amvr-cheat-sheet.jpg

A common question I get is how consistent are these numbers. Very consistent, as shown in the ten-year “cheat sheet.” as of the 3Q 2021.

Going Forward
John Langbein served as the Reporter on the committee that drafted the Restatement (Third) of Trusts. Once the Restatement was published, he made the following prediction:

When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.6

The 1st Circuit suggested the same outcome in its Brotherston decision”

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”

The Restatement (Third) of Trusts, Section 90, comment h(2) states that active strategies are imprudent unless it can be objectively anticipated that such strategies will provide a commensurate return for the additional costs and risks typically associated with such strategies/funds. So, to return to my two earlier suggestions:

  • An ERISA plaintiff’s attorney who can present evidence of the underperformance and cost-inefficiency of a plan’s investment options should defeat a motion to dismiss and should prevail on the merits.
  • A plan sponsor who is able to present evidence of the positive incremental performance and cost-efficiency of their plan’s investment options should be able to defeat an allegation of imprudent investment options. Such evidence would also provide proof of a plan actually designed to promote their employee’s “retirement readiness” and “financial well-being.

Notes
1. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
2. Restatement (Third) Trusts, Section 90, cmt. b. (American Law Institute. All rights reserved)
3. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
4. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
5. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
6. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law(1976). (Faculty Scholarship Series: Paper 498) available online at http://digitalcommons.law.yale.edu/fss_papers/498
7. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018

© Copyright 2021 InvestSense, LLC. All rights reserved.

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.

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, AMVR, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary responsibility, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , | Leave a comment

Rethinking Costs in 401(k) Litigation

Posted on November 15, 2021 by jwatkins

[C]ost-conscious management is fundamental to prudence in the investment function,…1

Two consistent themes of ERISA are cost-consciousness and risk management through diversification. With regard to cost-consciousness, studies have consistently shown that the overwhelming majority of actively managed mutual funds, the primary investment option in most 401(k) plans, are not cost-efficient.

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.2
  • 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.3
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.5

The studies’ findings are presumably based on the funds’ nominal, or stated, returns. However, there is an increasing awareness among investors and within the legal community, that nominal returns may not accurately reflect the degree of cost-inefficiency of actively managed funds

R-squared has been explained by Morningstar as follows:

R-squared measures the strength of the relationship between a fund’s performance and a benchmark’s performance, specifically, the degree to which a fund’s performance can be explained by the performance of the benchmark.

A higher R-squared value indicates a higher correlation, or relationship, between a fund’s performance and the benchmark’s performance, whereas a lower R-squared value indicates that a fund’s performance hasn’t behaved like the benchmark’s [performance]. R-squared is expressed as a percentage and ranges from 0%, or no correlation, to 100%, or perfect correlation, where a fund’s performance has moved in lockstep with the benchmark’s [performance.

A word of caution though: If a fund’s R-squared is very close to 100%, there’s a chance it may be hugging its index too closely, and that its returns can be replicated by an inexpensive fund that tracks that benchmark.6

In fact, over the past decade or so, there has a noticeable trend of U.S. domestic actively managed equity funds with r-squared numbers of 90 and above, many of 95 and above. Such high r-squared numbers strongly suggest that such funds may be fairly classified as “closet index” funds.

Closet index funds are actively managed mutual funds that claim to be providing active management and charge higher annual fees based on such representations. However, history has shown that such funds usually provide returns that are essentially the same or lower than comparable, less expensive index funds.

Martijn Cremers, creator of the Active Share metric, goes further, stating that actively managed mutual funds are arguably guilty of investment fraud.

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by for fees for active management that they do not receive or receive only partially….

Closet indexing raises important legal issues. Such funds are not just poor investments; they promise investors a service that they fail to provide. As such, some closet index funds may also run afoul of federal securities law.7

Based on the Morningstar definition of r-squared, it can be argued that r-squared provides a means for investors and investment fiduciaries to screen for closet index funds.

However, the value of r-squared as an analytical tool goes far beyond its use to screen for closet index funds. There is a growing trend within the legal community, in both ERISA and general securities litigation, to use r-squared to calculate the implicit damages from imprudent/unsuitable investment products.

One of the two thought leaders in this area has been Ross Miller. Miller is the creator of the Active Expense Ratio (AER) metric, which uses an actively managed fund’s r-squared number to calculate the fund’s implicit, and often excessive, expense ratio. Miller found that an actively managed fund’s AER was generally 4-6 times higher than its publicly stated expense ratio.

So why calculate an actively managed fund’s correlation-adjusted expense ratio? As Miller explains,

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund 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 index.8

Although not widely known, another advocate of the use of r-squared to determine the cost-efficiency of actively managed mutual funds was the legendary John Bogle. Bogle explained the value of both r-squared and factoring in a fund’s implicit costs as follows:

As active management continues to morph into passive indexing-already approaching the commonplace in the large-cap fund category-managers will have to reduce their fess commensurately. After all, a correlation of 99 comes close to meaning that 99 percent of the [the fund’s] portfolio is effectively indexed. A 1.5 percent expense ratio on the remaining portfolio, therefore, represents an annual fee of 150 percent(!) on the actively managed assets.

Even if investors are willing to tolerate that cost at the moment, it is only a matter of time until they realize that their ongoing deficit to the stock market’s return is a reflection of the simple fact that they effectively own an index fund, but at a cost that is grossly excessive.9

Bogle’s comments are obviously equally applicable to plan sponsors and other investment fiduciaries. Whether by using the AER or Bogle’s methodology, it can be argued that a fiduciary’s duty of prudence and the duty to avoid unnecessary costs requires that a fiduciary factor in an investment’s implicit costs.

This is yet another reason that the #Northwestern403 action currently pending before SCOTUS is so important, not just for plan sponsors, but for any and all investment fiduciaries. Many expect SCOTUS to uphold the notice pleading rule generally applied in the courts. If so, it would make sense that the Court will also rule that plan sponsors, rather than plan participants, have the burden of proof with regard to causation, or the prudence of their plan’s investment options.

Many have asked me whether I believe that r-squared and cost-efficiency are the future of fiduciary litigation. While no one knows for sure, my experience with my Actively Managed Value Ratio, which incorporates the AER in part, would support such an argument.

As the 3Q 2021 quarterly AMVR “cheat sheet” shows, the cost-inefficiency of some frequently used actively managed funds within 401(k) plans remains a serious issue for plan sponsors. Note the disparity between a fund’s nominal expense ratio and the fund’s implicit expense using the AER. Also note the direct relationship between a fund’s incremental costs, r-squared number and its AER.

FWIW, I would strongly suggest that the evidence regarding the cost-inefficiency of actively managed mutual funds, both in terms of their nominal and its correlation-adjusted/r-squared expense ratio, could make the potential burden of proof for plan sponsors and other investment fiduciaries, that much more formidable. That burden may be made even more difficult as there are some ERISA plaintiff’s attorneys who are already successfully using AER and implicit costs in calculating damages.

Notes
1. “Introductory Note” to Restatement (Third) Trusts, Section 90. (American Law Institute. All rights reserved.)
2. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
3.. 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.
4. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
5. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
6.“The Morningstar Dictionary: R-Squared” https://www.morningstar.com/articles/873622/the-morningstar-dictionary-r-squared)
7. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133.
8. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
9. John C. Bogle, “Don’t Count On It: Reflections on Investment Illusions, Capitalism, ‘Mutual’ FDuns, Indexing, Entrepreneurship, Idealism, and Her
oes,” (John Wiley & Sons: Hoboken, NJ, 2011), 432.

© Copyright 2021 InvestSense, LLC. All rights reserved.

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.






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3Q 2021 Top Ten 401(k) AMVR “Cheat Sheet”

Posted on October 31, 2021 by jwatkins

When InvestSense prepares a forensic analysis for a 401(k)/403(b) pension plan, a trust, an attorney, or an institutional client, we always do an analysis over five and ten-year time periods to analyze the consistency of performance. Since so many social media followers have asked this question, we are providing a forensic analysis for both time periods for our quarterly “cheat sheet” covering the third quarter of 2021.

At the end of each calendar quarter, we provide a forensic analysis of the top non-index mutual funds currently being used in U.S. 401(k) defined contribution plans. The list is derived from the annual survey conducted by “Pensions & Investments” and currently consists of six funds. Our forensic analysis is based on our proprietary metric, the Active Management Value Ratio™ 4.0 (AMVR).

The AMVR allows investors, fiduciaries and attorneys to determine the cost-efficiency of a fund relative to a comparable index fund. We typically use comparable Vanguard index funds for benchmarking purposes. People often ask why we do not use actual market indices like Morning star and actual funds. Actual market indices do not have costs, so they cannot be used to calculate a fund’s cost-efficiency.

In calculating a fund’s AMVR score, InvestSense compares a fund’s incremental risk-adjusted return to its incremental correlation adjusted costs. Five of the six funds do not qualify for an AMVR score, as they failed to provide a positive incremental return. While Dodge & Cost Stock did provide a positive incremental return, its, incremental correlation-adjusted costs exceeded its positive incremental risk-adjusted return. As a result, it would be deemed cost-inefficient under the AMVR.

Once again, five of the six funds do not qualify for an AMVR score, as they failed to provide a positive incremental return. While Dodge & Cost Stock did provide a positive incremental return, its, incremental correlation-adjusted costs exceeded its positive incremental risk-adjusted return. As a result, it would be deemed cost-inefficient under the AMVR.

People often ask about our uses of incremental risk-adjusted returns and incremental correlation-adjusted costs. As for our use of incremental returns, that is consistent with industry standards. While the financial services industry prefers to ignore risk-adjusted returns, “you can’t eat risk-adjusted returns,” it has no problem boasting about a good rating under Morningstar “star” system. I have to assume that the industry is not aware that Morningstar uses risk-adjusted returns in awarding its coveted stars.

The other justification for relying on risk-adjusted returns is that risk is generally thought to be a factor in return. As Section 90, comment h(2) 0f the Restatement (Third) of Trusts states, the use and/or recommendation of actively managed funds is imprudent unless it can be objectively determined that the active funds can be expected to provide investors with a commensurate return for the additional costs and risks associated with actively managed funds.

As for our use of correlation-adjusted costs, it allows us to use the AMVR to screen for “closet index” funds. Actively managed funds that have a high correlation to comparable, less-expensive are often referred to as “closet index” funds. Closet index funds are actively managed funds that tout the benefits of active management and charge higher fees than comparable index fund, but whose actual performance is actually similar to the comparable index funds. To be honest, “closet index” funds typically underperform comparable index funds.

Ross Miller created a metric, the Active Expense Ratio (AER), that allows investors and investment fiduciaries to determine the effective fee that they pay for actively managed mutual funds with high correlation, or R-squared, numbers. Miller explained the value of the AER:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund 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 index.

Martijn Cremers, creator of the Active Share metric, commented further on the importance of correlation of returns between actively managed mutual funds and comparable index funds, saying that

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices…. Investors in a closet index fund are harmed by for fees for active management that they do not receive or receive only partially…. Such funds are not just poor investments; they promise investors a service that they fail to provide. 

With those quotes in mind, it is interesting to note that all six of the actively managed funds on the 3Q cheat sheet all have R-squared/correlation numbers in the mid to high 90s.

Going Forward
Those that follow me on Twitter and/or LinkedIn know that I have posted a lot on those sites regarding the upcoming Supreme Court hearings in the Hughes v. Northwestern University 401(b) case. The oral arguments in the case are scheduled for December 6, 2021.

I will be posting more about the case as we get closer to the oral arguments. However, for now, I will just say that if the Court rules in favor of the plaintiff, it would essentially require plans to prove that the investment options they chose for a plan were prudent when they chose them.

Based on my experience with the AMVR and numerous forensic analyses for clients, I believe plans would be hard pressed to carry that burden. While the simplicity of the AMVR is often credited for its growing acceptance and use, the AMVR is still a powerful tool in 401(k)/403(b) litigation and pension plan risk management.  

Posted in 401k, 401k investments, Active Management Value Ratio, AMVR, asset allocation, consumer protection, cost consciousness, cost-efficiency, Cost_Efficiency, Fiduciary prudence, fiduciary responsibility, financial planning, prudence, retirement planning, wealth management, wealth preservation | Tagged , , , , , , , , , , , | 1 Comment