The Prudent Investment Fiduciary Rules

The Cost-Efficiency Standard: Streamlining the ERISA 401(k)/403(b) Litigation Process

Posted on April 15, 2019 by jwatkins

Any darn fool can make things bigger and more complex… It takes a touch of genius – and a lot of courage – to move in the opposite direction. – Albert Einstein

Simplicity is the ultimate sophistication. – Leonardo da Vinci

Do an actively managed mutual fund’s incremental returns exceed its incremental costs relative to a comparable index fund? Your basic Econ 101 cost/benefit analysis between two investment options. It’s just that simple.

The basic premise of ERISA is also simple:

ERISA is a comprehensive statute designed to promote the interests of employees and their beneficiaries in employee benefit plans.¹

And yet, it could be legitimately argued that a number of recent court decisions dismissing 401(k)/403(b) plan participant actions have seemingly gone out of their way to protect the investment industry at the cost of the plan participants. One such case, Brotherston v. Putnam Investments, LLC, has already been vacated by the First Circuit Court of Appeals.² Putnam has filed a petition for a writ of certiorari with SCOTUS, asking the Court to review the First Circuit’s decision.

My point in mentioning these cases is simply to suggest that in some of the recent dismissals involving 401(k)/403(b) actions, it seems that the courts involved have based their decisions on irrelevant, corollary issues, while totally losing sight of ERISA’s stated purpose-protection of a plan’s participants.

SCOTUS has recognized the legitimacy of the Restatement of Trusts in resolving fiduciary legal questions, especially those involving ERISA.

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.’³

Section 90 of the Restatement (Third) of Trusts (Restatement) sets out several relevant standards in determining whether a fiduciary has fulfilled its fiduciary duty of prudence, including

A fiduciary has a duty to be cost-conscious.⁴
In selecting investments, a fiduciary has a duty to seek either the highest level of a return for a given level of cost and risk or, inversely, the lowest level of cost and risk for a given level of return.^{^⁵}
Due to the impact of costs on returns, fiduciaries must carefully compare funds’ costs, especially between similar products.^{^⁶}
Due to the higher costs and risks typically associated with actively managed mutual funds, a fiduciary’s selection of such funds is imprudent unless it can be shown that the fund is cost-efficient.⁷

At the end of the day, I would argue that adopting a cost-efficiency standard would greatly streamline the litigation of 401(k)/403(b) actions by eliminating the consideration of irrelevant corollary issues, while at the same time furthering ERISA’s stated mission of protecting plan participants. If the goal of 401(k) and 403(b) plans is truly to protect and promote the “best interests” of plan participants as they work toward “retirement readiness,” the cost-efficiency of a plan’s investment options should be of primary concern.

Adopting a cost-efficiency standard as the preliminary and primary prudence standard in 401(k)/403(b) fiduciary breach actions would have streamlined the litigation process, and arguably ensured a fair and equitable outcome, in some recent actions by avoiding irrelevant issues such as a mutual fund’s business platform, the popularity of an actively managed fund, a fund’s amount of assets under management, and the legal recognition of a particular range of expense ratios within a plan based on absolute numbers alone.

By adopting a cost-efficiency standard as the preliminary and primary prudence standard in 401(k)/403(b) fiduciary breach actions, the court and the parties would only have to answer one simple two-part question:

At the time that the plan sponsor selected a particular actively managed fund for the plan:
(a) was the actively managed mutual fund cost-efficient in comparison to other comparable available funds, including index funds, and
(b) did the actively managed mutual fund further ERISA’s goal of properly protecting the plan participants’ best interests and providing them with the best opportunity to work toward “retirement readiness?”

That simple two-part question would address the burden of proof issues regarding both fiduciary prudence and causation of damages.Meaningless corollary issues, such as the “apples to oranges” and the concept of legally approved ranges of expense ratios arguments discussed in Brotherston and the “uniqueness” argument that has been put forth in various cases involving TIAA-CREF investments could be avoided.

Removing meaningless corollary issues from 401(k)/403(b) actions would simplify the issues for trial or settlement, by allowing the court and the parties to properly focus on the bottom line in ERISA actions-a fund’s performance relative to the costs incurred and the true impact on plan participants. As a former litigator, I can imagine conducting both direct examinations and cross-examinations in a case by just going through a plan’s list of actively managed funds and simply asking the plan sponsor and all the experts-cost-efficient or cost-inefficient?

Studies by well-respected investment experts and academicians have consistently found that the overwhelming majority of actively managed mutual funds are not cost-efficient.⁸ Actively managed funds typically have higher annual fees and higher trading costs than comparable index funds. An active fund’s only hope of covering those higher costs and fees is to outperform the comparable index fund.

But recent data suggests that more actively managed funds are currently guilty of “closet” or “shadow” indexing comparable index funds in order to avoid significant variances between the their returns and the index fund’s returns. The obvious fear is that such variances could result in the active fund’s customers moving their accounts to the comparable, less expensive index funds. But such “closet” indexing only ensures that an actively managed fund will continue to be cost-inefficient relative to a comparable, less expensive, index fund.

Going Forward
Does an actively managed mutual fund’s incremental returns exceed its incremental costs relative to a comparable index fund?

It’s just that simple. However, actively managed funds do not like to address the issues of cost-efficiency or “closet” indexing for obvious reasons. For some reasons, the lack of cost-efficiency of actively managed mutual funds is an issue that is not often addressed in the media.

And yet, the inclusion of so many cost-inefficient actively managed mutual funds is effectively preventing plan participants from having any hope of achieving the full extent of potential “retirement readiness” that they could possibly have with cost-efficient funds. As a result, ERISA’s stated purpose is being effectively denied.

By definition, mutual funds that are cost-inefficient can never qualify as a prudent investment. Investments whose relative costs exceed their relative returns are never prudent investments. Or, as the commentary to Section 7 of the Uniform Prudent Investor Act states, “wasting beneficiaries’ money is imprudent.”

The Restatement also establishes the imprudence of cost-inefficient actively managed mutual funds. That is why the courts should adopt cost-efficiency as both a preliminary and primary standard in deciding ERISA cases alleging a breach of a fiduciary’s duty of prudence. Prudent and proactive plan sponsors would be wise to also apply cost-efficiency as their preliminary and primary screens in selecting investment options for their plans, thereby minimizing the chance of unwanted and unnecessary fiduciary liability exposure for themselves.

A couple of years ago I created a simple metric, the Actively Management Value Ratio™ (AMVR), that allows investment fiduciaries, investors, and attorneys to evaluate the cost-efficiency of mutual funds. Based on the findings and concepts of investment experts such as Nobel Laureate Dr. William D. Sharpe, Charles D. Ellis and Burton G. Malkiel, the AMVR uses a minimal amount of data, all of which is freely available online, and only requires the basic math skills we all learned in elementary school (My Dear Aunt Sally-multiplication, division, addition and subtraction). For additional information on the AMVR and the required calculation process, click here.

One could argue that the First Circuit’s opinion in Brotherston v. Putnam Investments, LLC implicitly, if not expressly, validated cost-efficiency as both a preliminary and primary standard in 401(k)/403(b) fiduciary prudence actions, stating that

More importantly, the Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.

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.’⁹

As noted ERISA attorney Fred Reish likes to say, “forewarned is forearmed.”

Notes
1. Shaw v. Delta Airlines, Inc., 463 U.S. 85, 90 (1983).
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018).
3. Tibble v. Edison International, 135 S. Ct 1823 (2015).
4. Restatement (Third) Trusts, Section 90, cmt. b (American Law Institute).
5. Restatement (Third) Trusts, Section 90, cmt. f (American Law Institute).
6. Restatement (Third) Trusts, Section 90, cmt. m (American Law Institute).
7. Restatement (Third) Trusts, Section 90, cmt. h(2) (American Law Institute).
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; Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE, 179, 181 (2010); Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016; Mark Carhart, “On Persistence in Mutual Fund Performance,” 52 J. FINANCE, 52, 57-8 (1997).
9. Brotherston, at 39.

Posted in 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, closet index funds, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, ERISA liability, fiduciary, fiduciary investing, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment analysis tools, pension plans, prudence, wealth management, wealth preservation | Leave a comment

ERISA Risk Management and the Forensic ERISA Attorney

Posted on April 11, 2019 by jwatkins

I was at a reception last week when someone asked me the question I love to hear – “so, what do you do for a living?”

“I am a forensic ERISA attorney.”

Head tilt, accompanied by polite stare.

“I reverse engineer 401(k) and 403(b) plans.”

Head tilt, to the other side, polite stare.

Then I smiled and told them that I analyze 401(k) and 403(b) plans and, if needed, design “win-win” plans that provide plan participants with meaningful “retirement readiness” investment options, while also reducing the fiduciary risk of the plan and the plan fiduciaries. That explanation usually results in more questions and an interesting discussion. People may not like attorneys, but EVERYONE like to talk money and their retirement accounts.

Life’s too short not to have a little harmless fun. A friend of mine in PR suggested the “branding” title a couple of months ago. I’ll be paying her and her husband’s green fees for the awhile.

Interestingly enough, many people tell me that they may not remember my name after a meeting or event, since they meet so many people, but they always remember my title and what I do – “forensic ERISA attorney.” I often get several follow-up calls and/or emails after a meeting or an event. Again, people care about money and their retirement accounts. Plan sponsors care about avoiding, or at least reducing, any potential personal liability.

I have already posted several articles about the Putnam Investment, LLC v. Brotherston case and Putnam’s petition asking SCOTUS to hear their case. At this point, SCOTUS has not indicated whether it will hear the case.

I believe that we are at a pivotal point in the ERISA arena. Putnam is asking SCOTUS to reverse the First Circuit Court of Appeals decision in which the court ruled that once a plaintiff/plan participants shows that a plan violated its fiduciary duties under ERISA, the plan they has the burden of proving that the investments they chose for their plan did not cause the plan participants’ losses. (The SCOTUS filings are available here.)

If SCOTUS does grant certiorari and decides to uphold the First Circuit’s decision, or declines to hear the case at all, then Putnam will have the burden of proof on causation. I believe that the implications of that burden extend well beyond the immediate case.

The Cost-Efficicency Question
Based on the research of numerous noted and well-respected investment experts, the evidence overwhelmingly shows that most actively managed mutual funds are cost-inefficient, that they fail to cover their investment costs.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.¹

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.²

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.³

[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.⁴

These findings should not really come as a surprise to anyone. Actively managed funds typically have higher costs than comparable index funds due to higher management fees and higher trading costs. The challenge for actively managed funds is to then justify such higher fees/costs by producing higher returns for investors.

However, there seems to be an increasing trend of some actively managed funds choosing to essentially “track” the performance of a comparable index funds in order to avoid a significant deviation for the index fund’s performance. By avoiding significant differences in returns, actively managed funds hope to avoid the potential loss of clients.

However, this strategy of holding a fund out as being actively managed and charging higher fees for such purported services, while essentially providing the same returns as a comparable, yet less expensive, index funds is generally referred to as “closet” or “shadow” indexing. While “closet” indexing may reduce the risk of variances in returns, it effectively ensures the cost-inefficiency of the actively managed mutual fund involved, since there will be little chance of the active funds making up the cost differential between the active and the passive fund.

The issue of “closet” indexing is not just a U.S. phenomena. Canada and Australia have been among the leaders in addressing the problem. Questions are now being raised in the U.S. and internationally as to whether the strategy constitutes a securities violation since investors are not effectively receiving the services they were led to believe, at least to the extent they were led to believe.

At the end of each calendar quarter, I prepare a forensic analysis of the top ten non-index funds in U.S. defined contribution plans, based on “Pensions & Investments” annual survey. The analysis for the 1Q 2019 showed that all ten of the funds had a R-squared correlation score of over 90. This means that 90 percent or more of the ten funds’ five-year returns could be attributed to the performance of a relevant market index or index fund, rather than the contribution’s of the funds’ active management team. (InvestSense uses a five-year return period for analyses to reduce the chance of skew.)

My posts on the Brotherston decisions have resulted in a number of inquiries from pension plans asking me what they need to do and how to do it to reduce potential liability exposure. Since ERISA liability is based on past events over the last three or six years, there is nothing that can be done to avoid or minimize liability for past acts.

While no one knows what SCOTUS may do on the pending petition for cert, the good news is that regardless of the Court’s eventual decision, the prudent choice would be for plans and plan service providers to act proactively to ensure that their plan’s investment options are prudent and cost-efficient going forward, and to regularly monitor the plan’s investments, replacing those that are no longer cost-efficient. The ability to show that the plan had a fundamentally sound due diligence program in place and actually followed such system would be valuable in responding to any audits and/or ERISA claims that might arise.

Existing Legal Precedents
In closing, in my practice I offer ongoing fiduciary oversight services to make sure that plans are in, and remain in compliance with ERISA and up-to-date on industry trends. At the beginning of the year I always remind them of some basic 401(k)/403(b) risk management principles:

Monitor your plans’ investment options to ensure that they are cost-efficient and otherwise “objectively prudent,” including following the guidelines set out in the Restatement (Third) of Trusts. I recommend at least two plan prudence reviews annually. In defining “objective prudence,” with regard to defined contribution plans, the courts have stated that

[T]he determination of whether an investment was objectively imprudent is made on the basis of what the [fiduciary] 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.⁵(emphasis added)

Here the relevant ‘portfolio’ that must be considered is each available fund considered on its own…not the full menu of Plan funds. This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine [with another investment option], could have theoretically, in combination, created a prudent portfolio.⁶(emphasis added)
Plan fiduciaries cannot blindly rely on plan service providers or other third parties. ERISA requires that plan sponsors and other plan fiduciaries conduct their own independent and objective investigation. The failure of a plan’s fiduciaries to do so is a per se breach of their fiduciary duties.
While plan fiduciaries are allowed, even encouraged, to retain expert if the fiduciaries lack the experience or knowledge to select and monitor the plan’s investment options, the selection of and any reliance on such experts must be “reasonable” in order to be legally justified. So the obvious question is what constitutes “reasonable.” In defining the “reasonable” requirement regarding the selection of and reliance on experts the courts have consistently stated that

One extremely important factor is whether the expert advisor truly offers independent and impartial advice….⁷(emphasis added)

Plans sponsors will often tell me that they do not have time to deal with “all these rules;” that if they get audited or sued, they will simple say they did not know and/or understand ERISA’s rules. For any plans or plan sponsors considering such strategies, I offer two time-honored legal quotes:

ignorance of the law is no defense, and

a pure heart and an empty head are no defense [to a claim of the breach of one’s ERISA’s fiduciary duties.]⁸

Going Forward
I do believe that the Brotherston case is a potential turning point for 401(k)/403(b) plans, as the evidence strongly suggests that they will not be able carry the burden of disproving that actively managed mutual funds in their plan caused plan participants to suffer financial losses due to the relative cost-efficiency of the active funds. Furthermore, unless the mutual fund industry makes dramatic, and highly unlikely, changes in their current business platforms, it is unlikely that 401(k) and 403(b) plans that continue to opt for actively managed mutual funds as investment options within their plans will be able to meet the challenge of the burden of proof on causation going forward.

Just my opinion based on the overwhelming evidence. The situation reminds me of two quotes –

Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened. – Winston Churchill

It is difficult to get a man to understand something when his salary depends upon his not understanding it. – Upton Sinclair

Meanwhile, we anxiously await SCOTUS’ decision.

Notes
1. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE, 179, 181 (2010).
2. 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.
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997)
5. Fink v. National Sav. and Trust Co., 772 F.2d 951, 962 (D.C.C. 1984).
6. DiFelice v. U.S. Airways, 497 F.3d 410, 423 and fn. 8.
7. Gregg v. Transportation Workers of America Intern., 343 F.3d 833, 841 (6th Cir. 2003).
8. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983)

This article is for informational purposes only, and is not designed or 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, 404c, 404c compliance, Active Management Value Ratio, AMVR, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, investments, pension plans, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, evidence based investing, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, pension plans, prudence, retirement plans, wealth management, wealth preservation | Leave a comment

Putnam Investments, LLC v. Brotherston: Pivotal Point for 401(k)/403(b) Industries?

Posted on April 7, 2019 by jwatkins

Putnam Investments has filed a petition with the Supreme Court (SCOTUS) asking the Court to review the First Circuit Court of Appeals decision vacating a lower court’s decision that ruled in favor of Putnam. Brotherston had alleged that Putnam breached its fiduciary duties in connection with the company’s 401(k) plan by allowing excessive fees and selecting/maintaining imprudent investments within the plan.

The lower court had dismissed the action, alleging that Brotherston had not proven that the allegedly imprudent mutual funds were the cause of any losses sustained by the plan’s participants. The First Circuit ruled that Putnam, not Brotherston, had the burden of proving that the allegedly imprudent funds had not caused the plan participants’ losses. The court vacated the lower court’s ruling and remanded the case back to the district court for further consideration.

However, before the case could be sent back to the district court, Putnam decided to petition SCOTUS for a writ of certiorari. Non-legalese, they asked the Court to review the the First Circuit’s decision. Putnam has posed two questions to SCOTUS:

1. Whether an ERISA plaintiff bears the burden
of proving that ‘losses to the plan result[ed] from’ a
fiduciary breach, as the Second, Sixth, Seventh,
Ninth, Tenth, and Eleventh Circuits have held, or
whether ERISA defendants bear the burden of disproving
loss causation, as the First Circuit concluded,
joining the Fourth, Fifth, and Eighth Circuits.

2. Whether, as the First Circuit concluded, showing
that particular investment options did not perform
as well as a set of index funds, selected by the
plaintiffs with the benefit of hindsight, suffices as a
matter of law to establish ‘losses to the plan.’

I believe the second question is a mischaracterization of the facts and the applicable law. Prudence under ERISA law is not determined on the actual performance of of a plan’s investment options. Prudence is determined on the quality of the due diligence process that a plan sponsor and other plan fiduciaries used in conducting their independent investigation and evaluation of a plan’s potential investment options. Therefore, I will not focus as much on that question in this post. The bigger issue is the question as to who has the burden of proof on the causation issue.

Why Putnam Investments, LLC v. Brotherston Is Really Important
As Putnam has pointed out, there is currently a split in the various U.S. Court of Appeals with regard to who has the burden of proof regarding causation in ERISA actions. That is one argument for SCOTUS to hear the case in order to establish one uniform rule on the issue. Employees’ ERISA rights are too important to have the extent and protection of such rights depend on where an employee works and lives.

Just my opinion, but I believe SCOTUS has not yet decided whether to accept this case because they do not really want to accept it, as the First Circuit’s decision¹ was the proper decision and their opinion was a masterpiece that SCOTUS knows it does not, and cannot, improve on. However, SCOTUS may be wrestling with the need to establish one uniform rule on the issue.

As soon as Putnam announced that it was going to apply for cert, several clients and followers online asked me why they would do so. Again, just my opinion, but I think Putnam had to apply for cert due to the potential consequences of both the First Circuit’s decision and the potential nationwide application of the strong arguments they presented in their decision

The First Circuit’s Decision and the Future of the 401(k)/403(b) Industry
Having read the parties’ filings (scotusblog.com), as well as several amicus briefs filed by the investment industry, one thing seems clear. The industry understands the potential implications of the First Circuit’s decision for the 401(k)/403(b) industry as a whole. That is why I fell that Putnam had no choice but to file a petition for cert with SCOTUS.

As Brotherston points out in his response to Putnam’s petition

Petitioners contend that the actively managed funds in the Plan cannot be compared to index funds. However, leading economics professors recommend precisely this approach to measuring the value of active fund managers like Putnam. As Economics Nobel Laureate William Sharpe has stated: ‘[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’²

If the First Circuit’s decision is upheld by SCOTUS, or allowed to stand by SCOTUS refusing to grant cert, then the problem is that the industry knows it simply cannot meet the burden of proving that the overwhelming majority of actively managed mutual funds are prudent investments for plan participants. Since that burden of proof would actually fall on plan sponsors and, possibly possibly plan service providers if they are named as defendants in the 401(k)/403(b) litigation, both parties should closely follow the case to SCOTUS’ ultimate decision.

In their response to Brotherston’s response to their petition, Putnam suggests that any suggestion that index funds are a better investment option for plan participants would be “contrary to Congress’s design , [and] detrimental to plan participants….”³I addressed a number of those arguments in an earlier post

In their amicus brief, the Investment Company Institute (ICI) made a number of interesting statements:

Although fiduciaries will undoubtedly continue to act in participants’ best interests, the knowledge that their selections will be compared ex post to index funds and the onerous burden of disproving loss causation may lead plan fiduciaries to offer fewer investment options.⁴

First, fiduciaries do not always act in a plan participants’ best interests, as evidenced by the continuing number of ERISA fiduciary breach actions and subsequent settlements. Second, fiduciary liability is not based on an investment’s actual performance. As pointed out earlier, fiduciary liability is based solely on the quality of the due diligence process that a fiduciary used in evaluating and selecting prudent investments for the plan. The ICI is well-aware of that fact.

The ICI went on to state that

[B]asic financial planning stresses the importance of investing in a diversifiable mix of assets accessible through a variety of investment offerings. But the First Circuit’s decision pushes fiduciaries toward homogeneity, and the resultant decrease in options would hamper participant’s ability to build a diversified portfolio.⁵

While diversification is unquestionably a valuable component of prudent investing, true diversification involves investing in various categories of investments, e.g., large cap funds, small cap funds, growth funds, value funds. True diversification involves both horizontal diversification (investing across asset categories) and vertical diversification (within asset categories). Again, the ICI is well-aware of these facts.

Index funds are readily available in various categories that would easily allow plan participants to effectively diversify their retirement investment accounts. The ICI’s “homogeneity” argument regarding the potential exclusion of actively managed funds simply has no merit in any of the research materials I have ever read. Nobel Laureate Harry Markowitz’s Modern Portfolio Theory certainly was not based on the ICI’s index funds-actively managed funds “homogeneity” theory.

Studies by investment icons and leading professors have consistently reached the same conclusion – the overwhelming majority of actively managed mutual funds are not cost-efficient. Brotherston’s responsive pleading noted the finding of a study that concluded that

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.⁶

Brotherston also noted that comment m of Section 90 of the Restatement (Third) of Trusts (Restatement) cited an SEC study finding that “most actively managed funds failed to earn market returns net of their cost.”⁷ Brotherston also cited comment h(2) of Section 90, which essentially states that actively managed mutual funds are imprudent investment choices unless they are cost-efficient.

Other studies on the cost-efficiency of actively managed mutual funds have also concluded that such funds are largely not cost-efficient:

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

Signs of Desperation?
The First Circuit made the following statement in its decision:

More importantly, the Supreme Court has made it clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.

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.’¹¹

In its petition for cert, Putnam claims that the court’s statement constitutes an establishment of a “per se rule” regarding the use of index funds in proving losses in ERISA action. I published the First Circuit’s statement to let readers decide for themselves.

Brotherston responded to Putnam’s “per se rule” allegations by stating that the court’s statement was just that, a statement. Brotherston also pointed out that the court pointed out that plan sponsors will be immune from liability if they are successful in finding funds that are prudent selection process. Brotherston’s conclusion – “there is nothing in the First Circuit’s opinion that compels the use of index funds.¹²

The Evidence on the Cost-Efficiency of Actively Managed Mutual Funds
Several years ago I created a simple metric, the Actively Managed Value Ratio 3.0™ (AMVR). Based on the findings of Sharpe and investment icon Charles D. Ellis, the basic AMVR compares an actively managed mutual fund to a comparable index fund, comparing the incremental cost and incremental return of the two funds. Other adjustment are possible to screen for possible “closet” indexing and implicitly higher fees and costs.

At the end of each calendar quarter, I perform a forensic analysis of the top ten non-index funds in U.S. defined contribution plans. The ten funds are based on the “Pensions and Investments” annual list of the top mutual funds in U.S. defined contribution plans. My quarterly forensic analysis factors in key cost-efficiency factors such as different types of returns, R-squared correlation numbers, and “closet” indexing. The analysis for the first quarter is available here.

Additional information about the Active Management Value Ratio and its calculation process is available here.

Going Forward
While the First Circuit’s decision received widespread attention when it was announced, I have not seen much discussion on the decision since Putnam announced that it would petition SCOTUS for a writ of certiorari. Perhaps that will change once the Court announces whether it will hear the case.

I believe that the ultimate resolution of this case will be pivotal in the future of the 401(k)/403(b) industry, whether SCOTUS upholds the First Circuit’s decision or decides not to hear the case, leaving the First Circuit’s decision intact. If SCOTUS decides that plaintiff/plan participants have the burden of proof on the issue of causation, I believe that the plaintiffs’ bar can easily meet that burden by showing that the funds in question are cost-inefficient using the Active Management Value Ratio™ 3.0.

However, if the burden of proof on causation is ruled to rest with the plan sponsors and, possibly, plan service providers, based on the studies cited herein and my own forensic analyses, I believe both parties will be hard-pressed to carry their burden of proof on causation. As an ERISA attorney and risk management consultant to a 401(k)/403(b) plans, my concern is that most plans are not aware of the liability exposure and challenges that they may face.

The investment industry is well-aware of the potential impact that is involved for their business platforms. I personally believe that that is why we have seen such a dedicated opposition to any true fiduciary standard by the investment and the insurance industry. They know, and have known for some time, that the majority of the investment products they offer are not cost-efficient and, therefore, not in the best interests of pension plan and their participants.

If the burden of proof on causation is placed on plan sponsors and plan providers, I would not be surprised to see even more broker-dealers prohibit their brokers from providing services to 401(k)/403(b) plans due to the resulting potential liability exposure. As for protecting plan participants, I have no doubt that Vanguard and other no-load and low-load mutual fund companies, as well as fee-only advisers, would quickly step in to meet any and all needs.

In 1914, future legendary Supreme Court Justice Louis D. Brandeis predicted that the stock market would eventually crash due to the “self-serving [interests of] financial management and interlocking interests…”a victim of the relentless rules of humble arithmetic.”¹³ Actively managed funds sometimes do outperform comparable index funds. The problem is their significantly higher costs, due to management fees and higher level of trading, reduce their returns net of fees, resulting in underperformance relative to comparable index funds.

So the good news is that actively managed funds could become more cost-efficient relative to comparable index funds. However, the odds of them voluntarily reducing their management fees to the extent necessary to do so are unlikely, since most investors do not recognize the inherent issues.

As this case has unfolded, I cannot help but think about the prediction that John Langbein made over forty years ago. Langbein was the reporter for the committee that wrote the Restatement (Third) of Trusts. In analyzing the rules under the new Restatement, he offered the following advice:

When market [aka 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 vehicles. 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

Has that day arrived?

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1^st Cir. 2018) (Brotherston)
2. Brotherston Responsive Brief, 34, available at https://www.scotusblog.com. (Blog)
3. Putnam Response to Brotherston Response, 34
4. Amicus Brief of Investment Company Institute, 21
5. Amicus Brief of Investment Company Institute, 22
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. Restatement (Third) of Trusts, Section 90, cmt. m.
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. Brotherston.
12. Brotherston
13. Louis D. Brandeis, Other People’s Money and How Bankers Use It, (CreateSpace, 2009).
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

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, securities compliance, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, wealth management, wealth preservation | 1 Comment

Why 401(k)/403(b) Actions Are Far From Over…and How to Prevent Them

Posted on March 29, 2019 by jwatkins

When I read the district court’s decision in Brotherston v. Putnam Investments, LLC¹, I read all the social media stories and posting proclaiming the end of 401(k)/403(b) fiduciary breach actions. My email accounts were flooded with “I told you so” emails. I especially loved those emails citing the court’s “apples versus oranges” language.

I responded online by posting my opinion that the district court’s rationales were flawed and that the First Circuit would vacate the district court’s decision, which it did. My opinion was simply based on the actual facts that are involved in the current 401(k)/403(b) debate and applicable law.

Now here is the part that should concern plans, plan sponsors and plan service providers. In my opinion, the plaintiff’s bar has not yet made its strongest fiduciary breach argument

In Tibble v. Edison International², the Supreme Court acknowledged that the courts frequently turn to the Restatement (Third) Trusts (Restatement)³ to resolve fiduciary questions, especially those involving ERISA. Section 90 of the Restatement, commonly known as the “Prudent Investor Rule,” sets out various prudence standards for fiduciaries. Besides the basic fiduciary standards of loyalty and prudence, three particular standards have always stood out to me:

Fiduciaries have a duty to be cost-conscious. (cmt. a)⁴
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)⁵
Actively managed funds that are not cost-efficient, that do not cover their additional costs and risks, are legally imprudent. (cmt. h(2))⁶

From a potential fiduciary liability standpoint, comment h(2) is the potential time bomb. I believe the actively managed mutual funds cost-efficiency issue, along with the variable annuity issue, are the two reasons that the investment/financial service has been fighting any type of true fiduciary standard, as they know that very few of those two products can pass a true fiduciary standard in their current form.

Various studies by well recognized investment experts have concluded that most actively managed mutual funds are not cost-efficient.

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

The First Circuit also addressed the issue of risk-management within a plan and cost-efficiency in actively managed mutual funds, stating that

any fiduciary of a plan such as the Plan in this case can easily insulate itself byselecting 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.’¹⁰

“Facts Do Not Cease to Exist Because They Are Ignored”
Like it or not, the cost-inefficiency of actively managed mutual funds, as well as the associated issue of “closet” indexing, are going to have to be addressed by both the investment and financial services industries. With the string of recent questionable dismissals of 401(k)/403(b) fiduciary breach actions, the time for the ERISA plaintiff’s bar has come to fully address the issue.

In 2016, I created a simple metric, the Active Management Value Ratio (AMVR). Now in its fourth iteration, the AMVR allows plan, plan sponsors, plan participants and attorneys to easily evaluate the cost-efficiency of actively managed mutual funds. The AMVR only requires the basic My Dear Aunt Sally (multiplication, division, addition and subtraction) math skills that everyone learned in elementary school. The AMVR only requires 5-6 pieces of data, all of which are freely available online. Additional information on the AMVR and the calculation process required is available here.

I represent myself as a forensic ERISA attorney. Based upon my time as a compliance director in the brokerage and RIA business, my services include performing forensic investment analyses for pension plans, trusts, and attorneys. My experience with regard to the cost-efficiency issue has been consistent with the previously mentioned studies-the majority of actively managed mutual funds are not cost-efficient.

Those findings should not come as a surprise to anyone if they objectively consider the current situation. The Morningstar Investment Research Center recently reported that the average expense ratio of a U.S. domestic large cap mutual fund was 1.11% (111 bps), as compared to the 0.17 expense ratio (17 bps) of the Vanguard Growth Index Investor shares.

Common sense should tell a plan sponsor or other investment fiduciary that if an actively managed fund has a high R-squared, or correlation of return, number to a comparable index fund, it is highly unlikely that the actively managed fund is going to outperform a comparable index to the extent necessary to make up the cost difference between the two funds. Based on my experience, even when an actively managed fund does outperform a comparable index fund, the difference in returns is usually less than 0.50% (50 bps).

Bottom line-the greater the incremental cost between an actively managed mutual fund and a comparable index fund, the greater the likelihood of the actively managed fund being cost-inefficient, and thus violating the Restatement’s cost-efficiency requirement.

Furthermore, since costs are essentially negative returns, the size of an actively managed fund’s incremental costs will also reduce the fund’s annualized returns, further increasing the negative impact of an actively managed fund on a plan participant’s end-return and “retirement readiness.”

“Closet” Indexing
As more focus has been directed toward the issues of cost-efficiency and the underperformance of actively managed mutual funds r4elative to lower-cost index funds, the issue, and costs, of “closet,” or “shadow,” indexing has gained greater attention.

A former general counsel of the Securities and Exchange Commission made these comments addressing “closet” indexing:

The presence of the virtual hedge fund is, of course, why you chose active management. If there were zero holdings in the virtual hedge fund — no overweightings or underweightings — then you would have only an index fund.

Indications from the academic literature suggest in many cases the virtual hedge fund is far smaller than the virtual index fund. Which means…investors in some of these [actively managed funds]… are paying the costs of active management, but getting instead something that looks a lot like an over-priced index fund.

So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether or not they’re getting the desired bang for their buck?¹¹

While there is no universally agreed upon “line in the sand” to determine a fund’s status as a “closet” index fund, there is a generally agreed upon concept of a “closet” index funds’ basic characteristics. Two different metrics are currently used to identify potential “closet” index funds. One metric, developed by K. J. Martijm Cremers, is known as Active Share. Active Share essentially measures the overlap between an actively managed mutual fund and a comparable index, or benchmark fund. In describing “closet” indexing, Cremers has stated that

Closet indexing in U.S. mutual funds is a problem that harms investors through high costs and low returns. Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially.¹²

The second metric currently being widely used to identify potential “closet” index funds is known as the Active Expense Ratio (AER). Developed by professor Ross Miller, the AER factors in an actively managed fund’s R-squared, or correlation of returns, number and the fund’s incremental, or additional, costs, to produce a fund’s AER number, or effective expense ratio. In addressing “closet” indexing and the AER, Miller has stated that

[M]utual funds are more expensive than commonly believed. Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.¹³

Legal Liability Issues
Based upon my experience, I believe that very few plan fiduciaries and plan service providers consider a plan’s cost-efficiency and potential “closet” indexing classification when selecting and monitoring a plan’s investment options. As a result, as plaintiffs’ attorneys focus more on both issues, I believe that not only will we see a continual stream of 401(k)/430(b) fiduciary breach actions, but also a stream of large settlements. The evidence is abundant and persuasive.

In my opinion, most of the arguments put forth by the courts as grounds for dismissing fiduciary actions, such as a fund family’s business platform, legally approved ranges of expense ratios, amount of money currently invested in an actively managed fund and the number of investments offered by a plan, are totally inconsistent with ERISA’s stated goal of protecting plan participants and/or have already been rejected by courts. Another reason for my belief that 401(k)/403(b) breach of fiduciary actions will continue and be successful.

Going Forward
I have presented the bad news. Now, the good news. By identifying and acknowledging any cost-efficiency and/or “closet issues that exist within their plan, , proactive plan sponsors and plan service providers can easily create a win-win 401(k) or 401(b) plan. A win-win plan is one that truly assists plan participants in working toward “retirement readiness,” while also protecting plan sponsors and other plan fiduciaries from unwanted unlimited personal liability., making life good for everyone…except plaintiffs’ attorneys.

As my colleague, the highly respected ERISA attorney Fred Reish, is fond of saying, “forewarned is forearmed.”

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1^st Cir. 2018) (Brotherston)
2. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
3. Restatement (Third) Trusts (American Law Institute) (Restatement)
4. Restatement, Section 90, cmt. b.
5. Restatement, Section 90, cmt. f.
6. Restatement, Section 90, cmt. h(2).
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, 52, 57-8.
10. Brotherston.
11. SEC Speech: The Future of Securities Regulation; Philadelphia, Pennsylvania; October 24, 2007 (Brian G. Cartwright), available online at http://www.sec.gov/news/speech/2007 /spch102407bgc.htm (last visited Mar 27, 2012).
12. K.J. Martijn Cremers Quinn Curtis, “Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds”, 42, 67 available online at https://bit.ly/2FHKJQE.
13. Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” 1, available online at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, best interest, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, prudence, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, fiduciary investing, fiduciary law, Fiduciary prudence, investment analysis tools, pension plans, prudence, wealth preservation | Leave a comment

The Active Management Value Ratio FAQs

Posted on March 18, 2019 by jwatkins

Glad to get the feedback from people who like and are actively using the Active Management Value Ratio™ 3.0 (AMVR). I though I would share some of the frequently asked questions (FAQs) in case they help others using the AMVR metric.

Is the AMVR intended to be used to predict a mutual fund’s future performance?
No. Investment fiduciaries are held to very high fiduciary duties, including the duties of loyalty and prudence. The purpose of the AMVR is to analyze the cost-efficiency of an actively managed mutual fund. Funds that are not cost-efficient waste investors’ money. “Wasting beneficiaries’ money is imprudent.”

Why do some AMVR slides show three types of returns, while other slides only show two types of returns?
Slides for shares of mutual funds that charge a front-end load, or commission, show (1) a fund’s stated, or nominal return; (2) a fund’s return adjusted for the fund’s front-end load; and (3) a fund’s risk-adjusted return.

Most mutual funds do not charge a front-end load on retirement shares offered through pension plans such as 401(k) and 403(b) plans. Therefore, slides for shares of retirement shares only show a fund’s five-year annualized nominal and risk-adjusted returns.

Is cost-efficiency that important? Doesn’t the law require stockbrokers and other financial advisers to watch out for that sort of thing, to always put a customer’s financial “best interests” first?
“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.”

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

Investment fiduciaries are required to always put their client’s “best interests” first, to always put a customer’s financial interests ahead of their own.

Inexplicably, there are currently two different standard for professionals providing investment advice to the public. Stockbrokers are not generally not held to a fiduciary standard. As a result, they can put their own financial “best interests,” i.e., commissions, trips, ahead of the customer’s best interest. Investment advisers are held to the aforementioned fiduciary standard of putting a customer’s “best interests” first.

Does the AMVR provide any other information about cost-efficiency?
Yes. Here, the the fund’s AMVR using the fund’s TER (traditional expense ratio) would be 0.73%. The fund’s AMVR using the fund’s AER (active expense ratio) would be 7.44%.

Look at the % fee/% return line on the AMVR chart. 83%/6% indicates that 83% of the actively managed fund’s costs are only producing 6% of the fund’s risk-adjusted return.

Another analogy would be to “monetize” the funds’ annual costs in another way. Which would you prefer to pay-$18 for a return of $7.26, or $111 for a return of 7.73%, 93 extra basis points in costs for 47 extra basis points of return?

Is the AMVR the same thing as the Sharpe ratio?
No. The AMVR compares a mutual fund’s costs to the fund’s returns.

The Sharpe ratio compares a mutual fund’s risk to the fund’s returns.

Why are a fund’s trading expenses included in the calculation of AMVR? Aren’t a mutual fund’s trading expenses part of a mutual fund’s expense ratio?
No. Trading expenses are part of a mutual fund’s operating expenses, which are not included as part of a mutual fund’s expense ratio. Trading expenses reduce a mutual fund’s return and are often higher than a fund’s expense ratio.

The importance of trading expenses cannot be emphasized enough. Often referred to a part of a mutual fund’s “hidden” expenses, studies have consistently recognized the importance of trading expenses on mutual funds’ returns.

A Wall Street Journal article, “The Hidden Costs of Mutual Funds,” estimated that the average trading costs of actively managed funds are 1.44 percent of a fund’s total assets. The Morningstar Investment Research Center reports that as of March 2019, the average expense ratio of U.S. domestic mutual funds is 1.11 percent.

Each additional 1 percent in fees and costs reduces an investor’s end return by approximately 8 percent over 10 years, 17 percent over 20 years. Using the above-referenced expense ratio and trading cost numbers, investor’s would be looking at a loss of 20 percent and 43 percent respectively. That’s is why trading costs are a part of the AMVR’s cost-efficient calculation.

For example, at the end of each calendar quarter, InvestSense, LLC, calculates the cost-efficiency of the top ten 401(k) mutual funds, based on “Pensions & Investments’” annual list of the top fifty mutual funds in U.S. defined contribution plans, based on cumulative invested dollars in said plans.

At the end of the fourth quarter for 2018, two funds had identical five-year annualized returns. However, one fund had a turnover ratio that was 600% higher than the other fund, indicating higher trading costs. Costs are anti-performance, negative returns. Therefore, the turnover/trading numbers helped the investor make a more-informed decision and, hopefully achieve higher returns.

As stated in the earlier Burton Malkiel quote, his studies have concluded that a fund’s expense ratio and its trading costs are the two most reliable indicators in predicting a mutual fund’s future performance. He went on to say that “[h]igh expenses and high turnover depress returns.”

As the late Vanguard legend, John Bogle, was fond of saying – “costs matter.”

What is AER and why is it included in calculating a fund’s AMVR?
A fund’s Active Expense Rating, or AER number, helps investors detect and avoid co-called “closet index funds. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but charge much higher fees than the index fund.

As Ross Miller, the creator of the AER explained:

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

A fund’s AER number is based on a fund’s R-squared number. Morningstar states that R-squared reflects the percentage of a fund’s movements that are explained by movements in its benchmark index, [rather than any contribution by active management.]

An R-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to an index fund rather than the active fund’s management team. If an investor is paying an annual expense fee of 1% for an actively managed mutual fund that only contributes 2 percent of the fund’s total return, and a comparable index fund is producing 98% of the fund’s return, while charging an annual expense fee of just 0.20% percent, the effective annual expense ratio for the actively managed fund is significantly higher than the stated 1%.

I noticed you use Vanguard index funds as the benchmarks in your AMVR analyses? Can funds from other fund families be used for benchmarking purposes?
Absolutely. Every so often I run a screen on the Morningstar Investment Research Center application to see how Vanguard funds measure up for benchmarking purposes. ERISA’s stated purpose is to protect plan participants. Plan sponsors talk about “retirement readiness,” about helping plan participants reach their retirement goals. The best way to do that is to provide plan participants with mutual fund that provide them with cost-efficient investment options.

I recently ran my Morningstar cost-efficiency screen on all nine of Morningstar’s equity box categories. Here is the screen I ran for the large-cap growth category (1516 funds), both for Vanguard’s large cap Growth Index retail shares (VIGRX) and retirement shares (VIGAX):

	VIGRX	VIGAX
Nominal Return (5-yr) >=	422	392
Load-adj. Return (5-year) >=	358	335
Expense Ratio <	9	6
Turnover <	4	2
STDEV <	4	1
R-squared < 90	3	1

The 3 funds that passed the VIGRX screen were Vanguard Growth Index Admiral shares, Vanguard Growth Index institutional shares, and Vanguard Growth Index Investor shares. The only fund that passed the VIGAX screen was…Vanguard Growth Index Admiral shares. Pretty strong evidence.

People can argue all they want about using Vanguard index funds for benchmarking purposes. If the goal is truly about helping promote the participants’ “retirement readiness,” then Vanguard is clearly the best choice. The First Circuit Court of Appeals recently gave further support to the use of index funds, both for benchmarking purposes and within plans, in their decision in Brotherston v. Putnam Investments, LLC.

In deciding on benchmarks, I would strongly suggest that investment fiduciaries, such as plan sponsors, and investors run similar screens on the funds they are considering. Most public libraries now offer the Morningstar Investment Research Center program for free in their digital library.

Can I use the AMVR to evaluate exchange traded funds (ETFs)?

Yes.

Can I use the AMVR on the subaccounts in a variable annuity?
Yes. Variable annuity subaccounts usually track the performance of the retail version of the mutual fund. Just be sure to use the information on the fund contained in the variable annuity’s prospectus.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, best interest, closet index funds, cost consciousness, cost efficient, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, best interests, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, wealth management, wealth preservation | Leave a comment

May It Please the Court: The Cost-Efficiency Quotient

Posted on March 8, 2019 by jwatkins

In my last post, I suggested that the correlation of returns between funds in a 401(k)/403(b) plan might be considered the “X” factor in ERISA litigation going forward. In this post, I want to discuss another emerging factor in ERISA 401(k)/4o3(b) excessive fees/breach of fiduciary litigation: cost-efficiency.

In the Tibble decision, SCOTUS expressly recognized the Restatement (Third) Trusts (Restatement) as a legitimate resource for resolving fiduciary questions, especially those involving ERISA. Section. Section 90 of the Restatement, otherwise known as the Prudent Investor Rule, establishes several standards that investment fiduciaries, including plan sponsors should be aware of:

fiduciaries have a duty to be cost-conscious (cmt. a)
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), and
actively managed funds that are not cost-efficient, that do not cover their additional costs and risks, are imprudent. (cmt. h(2)).

At the end of each calendar quarter, InvestSense conducts a forensic analysis of the top ten non-index mutual funds from “Pensions and Investments” annual survey of the top mutual funds in defined contribution plans, based on invested assets in U.S. 401(k) plans. I recently used our proprietary metric, the Cost-Efficiency Quotient (CEQ) to analyze the cost-efficiency of the top ten funds in our current quarterly analysis.

In calculating a fund’s cost-efficiency InvestSense uses John Bogle’s “all-in” costs metric, which includes a proxy for an actively managed fund’s trading expenses. Trading costs are not included in a fund’s annual expense ratio number, as they are included in a fund’s operation costs. The problem is that trading costs are not broken out separately in operational cost. Therefore, an investor or investment fiduciary is not able to include an exact number for trading costs.

Trading costs are often simply too significant to ignore in calculating a fund’s cost-efficiency. In fact, trading costs are sometimes greater than a fund’s annual expense ratio.

To avoid frivolous arguments, we also calculate a fund’s CEQ based only on a fund’s annual expense ratio. The annual expense ratio-only CEQs for the retirement shares of the current top ten funds are as follows

Vanguard PRIMECAP – 40%
Fidelity Growth Company – 26%
TRP Blue Chip Growth – 18%
TRP Growth Stock – 7%
Fidelity Contrafund – 5%
AF Growth Fund of America – 4%

AF Washington Mutual, AF Fundamental, Dodge & Cox Stock, and MFS Value all underperformed their respective benchmark, so their cost-efficiency number was zero. Vanguard’s Growth Index (LC), Value Index (LV) and the S&P 500 Index (LB) funds were used for cost and return comparative purposes.

The Active Expense Ratio (AER) is a metric that factors in the impact of correlation of returns on an actively managed fund’s annual expense ratio. The higher the correlation of returns between between an actively managed and a comparable index fund, the lower the effective contribution of active management. Created by Ross Miller, the AER allows plan sponsors and plan participants to to identify and avoid “closet” index funds and their unnecessary fees and costs. Closet index funds are imprudent investments.

The AER-adjusted CEQs for the retirement shares of the current top ten funds are as follows

Vanguard PRIMECAP – 25%
Fidelity Growth Company – 22%
TRP Blue Chip Growth – 16%
TRP Growth Stock – 6%
Fidelity Contrafund – 4%
AF Growth Fund of America – 2%

Just as with the annual expense ratio-only CEQs, AF Washington Mutual, AF Fundamental, Dodge & Cox Stock, and MFS Value all underperformed their respective benchmark, so their cost-efficiency number was zero. Vanguard’s Growth Index (LC), Value Index (LV) and the S&P 500 Index (LB) funds were used for cost and return comparative purposes.

Two obvious observations:

No fund managed to post a cost-efficiency number of 50% of higher, using either an annual expense ratio-only CEQ or an AER-adjusted CEQ. In fact, only three of the ten funds even posted a cost-efficiency number in double digits.
With the exception of the Vanguard PRIMECAP fund, the cost-efficiency numbers for the funds were essentially consistent regardless of the cost method used.

Going Forward
So what do the CEQ numbers mean for ERISA plan sponsors and ERISA attorneys? For ERISA plan sponsors, cost-efficiency should definitely be incorporated into the plan’s due diligence process. Based on my experience as an ERISA attorney, far too many plan sponsors only look at a fund’s annualized returns and standard deviation in selecting funds for their plan. This limited evaluation often results in imprudent investments and unwanted and unnecessary liability for a 401(k)/403(b) plan and the plan’s fiduciaries.

Plan advisers and mutual funds do not like to discuss the cost-efficiency of the funds they recommend or select, for reasons shown herein. Maybe that is why so many plan advisers bury fiduciary disclaimer clauses in their advisory contracts, leaving plan sponsors exposed to any and all liability in connection with the funds actually chosen for their plans, even if the plan adviser recommended such investments.

Advisers and funds also do not like to discuss the issue of “closet indexing.” Closet indexing is evident when a fund claims to provide active management, but actually provides the same returns as a comparable, less expensive, index fund, albeit at much higher fees. Closet index funds are not cost-efficient.

Even worse, some plan sponsors do not perform their legally required individual investigation and analysis. The courts have consistently stated that the failure of a plan sponsor to conduct their own investigation is a clear breach of their fiduciary duties.

Studies have shown that most actively managed mutual funds simply are not cost-efficient.

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.¹
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.²
[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.³

For attorneys, focusing on cost-efficiency appears to provide a clear advantage for plaintiff’s attorneys. First, cost-efficiency issues create genuine questions of fact. Since judges are allowed to only rule on questions of law, incorporating cost-efficiency issues in a action should preclude early dismissals of 401(k)/403(b) actions. Incorporating cost-efficiency issues in an action would also provide a legitimate means of getting the court to focus on the meaningful issues, the “retirement readiness” and overall best interests of the plan participants and their beneficiaries, rather than some of the questionable corollary issues that have been cited in recent court decisions dismissing 401(k)/403(b) actions.

As the late John Bogle was fond of saying, “costs matter.” Prudent plan sponsors and other investment fiduciaries will factor in all costs associated with a fund and determine whether the fund is cost-efficient, thereby providing a plan participant’s with an opportunity to improve and protect their financial security.

This article is for informational purposes only. It is neither designed nor intended to provide legal, investment, or other professional advice as 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.

Notes
1. 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.
2. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
3. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, pension plans, prudence, retirement plans, wealth management, wealth preservation | Leave a comment

Correlation of Returns: The ERISA 404(c) Fiduciary “X” Factor

Posted on March 4, 2019 by jwatkins

I received an email the other day from a local 401(k) plan. The email was short and simple – “we would you like you to come and present your ‘404(c) Fiduciary Liability Circle’ presentation.” After I gave the presentation, I got the typical response from the plan’s investment committee – “how soon can we implement the program?”

Several courts have recently dismissed 401(k)/403(b) actions alleging excessive fees and/or a breach of fiduciary duties by a plan’s sponsor. These dismissals have resulted in various articles and social media posts predicting the end of such legal actions.

As Mark Twain reportedly said, “reports of my demise have been greatly exaggerated.” A closer look suggests that predictions of the end of 401(k)/403(b) litigation are extremely premature. Or, as I tell colleagues, “the Fat Lady is far from singing.”

I have posted several articles regarding my belief that too many investment fiduciaries and ERISA plans have overlooked Section 90, comments h(2) of the Restatement (Third) Trusts (Restatement).¹ Comment h(2) essentially states that a fiduciary’s use of actively managed mutual funds that are not cost-efficient is imprudent.

The Restatement’s position is even more important given the various reports that have found that the overwhelming majority of actively managed mutual funds are not cost-efficient, as they cannot even cover their fund’s fees/costs.

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.²

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.³

[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.⁴

During my presentation of the “401(k) Fiduciary Liability Circle,” I always ask a plan’s investment committee if they considered the correlation of returns between the funds under consideration for their plan. Typically, the answer is “no.” Did the plan’s service provider provide them with that information? Again, “no.” Did they ask the service provider to provide such information? About this time, I often get the question – “What is correlation of returns and why is it even important.”

ERISA Section 404(c)
Many 401(k)/403(b) plans elect 404(c) status, as it may insulate the plan and plan sponsors from liability for the actual performance of the plan’s investment options. However, there are over twenty requirements that must be met to qualify for 404(c) protection. Based on various reports, few plans ever qualify as a 404(c) plans.

Based on my experience, even fewer plans are actually aware of the language set out in ERISA regarding Section 404(c). Let’s change that.

(b) ERISA section 404(c) plans –

(1) In general. An “ERISA section 404(c) Plan” is an individual account plan described in section 3(34) of the Act that:

(i) Provides an opportunity for a participant or beneficiary to exercise control over assets in his individual account; and

(ii) Provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his account are invested.⁵ (emphasis added)

So, to qualify for 404(c) protection, a plan must provide a plan participant or beneficiary with

(a) an opportunity to exercise control over the assets in their 401(k)/403(b) account; and (b) an opportunity to choose the investments for their account from a “broad range” of investment options.

So how does a plan satisfy the “exercise control” requirement?

(2) Opportunity to exercise control.

(i) a plan provides a participant or beneficiary an opportunity to exercise control over assets in his account only if:

(B) The participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed investment decisions with regard to investment alternatives available under the plan, and incidents of ownership appurtenant to such investments….⁶ (emphasis added)

So now we have the added requirement of a plan providing a plan participant or their beneficiary with “sufficient information to make informed investment decisions.” The obvious question is what constitutes “sufficient information?” ERISA 404(a)-5 specifies certain investment information that a plan must provide to plan participants for each investment option within a plan. A fund’s invest fees and expenses are among the information that must be provided.

Last question – how does a plan satisfy the “broad range” of investment options requirement?

(3) Broad Range of Investment Alternatives

(i) A plan offers a broad range of investment alternatives only if the available investment alternatives are sufficient to provide the participant or beneficiary with a reasonable opportunity to:

(A) Materially affect the potential return on amounts in his individual account with respect to which he is permitted to exercise control and the degree of risk to which such amounts are subject;

(B) Choose from at least three investment alternatives:

(3) Broad range of investment alternatives

(1) Each of which is diversified;

(2) Each of which has materially different risk and return characteristics;

(3) Which in the aggregate enable the participant or beneficiary by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary; and

(4) Each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant’s or beneficiary’s portfolio;

(C) Diversify the investment of that portion of his individual account with respect to which he is permitted to exercise control so as to minimize the risk of large losses, taking into account the nature of the plan and the size of participants’ or beneficiaries’ accounts. In determining whether a plan provides the participant or beneficiary with a reasonable opportunity to diversify his investments, the nature of the investment alternatives offered by the plan and the size of the portion of the individual’s account over which he is permitted to exercise control must be considered.⁷ (emphasis added)

Essentially what this section of 404(c) is doing is reinforcing the importance of controlling costs and risk management through effective diversification within an investment account. with providing plan participants and beneficiaries with a selection of investment options that allow them to effectively diversify their account in order to minimize the risk of large losses. In fact, the two primary themes you see throughout ERISA is the importance of providing plan participants with effective means to control costs and to minimize the risk of large losses.

Control costs. Minimize the risk of large losses.

Controlling Costs and Correlation of Returns
Controlling investment costs is obviously integral to controlling one’s 401(k)/403(k) account. The compounding of investment fees and expenses can significantly reduce an investor’s end return. Each additional 1 percent in fees and expenses reduces an investor’s end-return by approximately 17 percent over a twenty year period.

Actively managed funds continue to be the primary investment options offered within most 401(k)/403(b) plans, although reports are that pension plans are making some adjustments. However, as previously mentioned, a number of studies have found that most actively managed funds are not cost-efficient, as they cannot even produce incremental returns that cover their fees and costs.

This becomes even more troubling when one considers the studies regarding the current concern over “closet” or “shadow” indexing. Professor Ross Miller of the State University of New York/Albany did a study on the impact of closet indexing. His findings were extremely interesting.

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

In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment.

Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.⁸

What Professor Miller found was that when factoring in the correlation of returns between an actively managed mutual fund and a comparable index fund, actively managed funds often charge an effective annual expensive ratio that is often 500-600 percent higher than the fund’s publicly stated expense ratio.

So considering the correlation of returns between an actively managed mutual fund and a comparable, but less expensive, index fund can help plan participants and their beneficiaries to control costs. As the saying goes, “you get what you don’t pay for.” Less in the fund’s pocket means higher returns for an investor.

Risk Management and Correlation of Returns
Harry Markowitz won a Nobel Prize for developing the concept of Modern Portfolio Theory (MPT). While valid criticisms of MPT have been raised, MPT’s core concept of managing portfolio risk through effective diversification of a portfolio’s assets is still valid and valuable.

The key word is effective diversification. Too many investors mistakenly believe that choosing a number of mutual funds from different asset categories, i.e., large cap growth fund, small cap value fund, domestic bond fund, international fund, is effective diversification.

Markowitz correctly described effective diversification:

To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little more protection than the uncertain return of a single security.

Effective diversification depends not only on the number of assets in a trust portfolio but also on the ways and degrees in which their responses to economic events tend to reinforce, cancel or neutralize one another.⁹

So, factoring in the correlation of returns between the investments in a portfolio hopefully helps investors protect against large losses. No one can predict the performance of the stock market. However, 401(k)/403(b) plans that can show that they did factor in correlation of returns can show that they employed a prudent process in selecting a plan’s investments, as required by ERISA.

The investment industry often points out that ERISA does not specifically require that plan advisers and plan sponsors provide correlation of returns data to plan participants. It is also true that ERISA does not specifically prohibit plans and plan sponsors from providing such information either. Furthermore, ERISA specifically authorizes the provision of information about key investing concepts.

Correlation of returns information is essential in effectively diversifying an investment portfolio in order to avoid large losses, one of ERISA’s stated goals. Therefore, a prudent plan investment committee will have considered such information in properly performing the due diligence investigation and evaluation required by ERISA. Therefore, providing such information to plan participants would clearly impose no hardship or additional cost on the plan or the plan sponsors. Perhaps this is simply another emerging issue for future 401(k)/403(b) litigation.

Going forward
As I have suggested before, I believe that we are going to see the plaintiff’s bar begin to focus more on the issues of cost-efficiency and “closet” indexing in 401(k) excessive fees/breach of fiduciary duty actions. Mutual funds and plan service providers do not like to talk about cost-efficiency or “closet” indexing. Plan sponsors must insist on such information in order to properly both the plan and themselves against fiduciary liability.

The investment industry knows, and has known for some time, that most actively managed funds are neither cost-efficient nor prudent. In my opinion, that is why the investment industry has fought so strongly to prevent any true fiduciary standard from being adopted by the Department of Labor and the Securities and Exchange Commission.

That is why plan service providers often include fiduciary liability disclaimer language in their advisory contracts with pension plans. Many plans apparently do not closely read their advisory contracts. As a result, they are either completely unaware that such language is in their advisory contract or they do not truly understand the significance of such disclaimer.

401(k)/403(b) excessive fees/breach of fiduciary duty actions are not going away anytime soon. Nor should they, as these plans have sometimes been the victim of questionable, conflicted advice from their plan advisers. As a result, many plan sponsors are not truly aware of the extent of unlimited personal liability exposure they are facing or the changes that need to made within their plan.

Plans should never agree to an advisory contract that contains a fiduciary disclaimer clause. If the plan’s service provider does not have confidence in their advice, why should a plan sponsor?

For proactive investment fiduciaries and service providers, this presents a perfect opportunity to demonstrate their value added proposition to a plan. That is exactly why I created my “401(k) Fiduciary Liability Circle” presentations – “Why” and “How.” And yes, they are copyright protected.

Notes
1. Restatement (Third) Trusts, Section 90, cmt h(2). American Law Institute.
2. Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017.
3. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
5. ERISA 29 CFR § 2550.404c-1(b)(1)
6. ERISA 29 CFR § 2550.404c-1(b)(2)
7. ERISA 29 CFR § 2550.404c-1(b)(3)
8. Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926
9. Harry M. Markowitz, Portfolio Selection, 2nd Ed. (Cambridge, MA: Basil Blackwood & Sons, Inc., 1991), 5.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, closet index funds, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, pension plans, prudence, retirement plans, wealth management, wealth preservation | 1 Comment

The First Circuit’s Putnam Decision – Where Does ERISA 401(k)/403(b) Litigation Go Now?

Posted on February 22, 2019 by jwatkins

The First Circuit Court of Appeals (First Circuit) recently handed down its decision in Brotherston v. Putnam Investments, LLC. The First Circuit vacated the lower court’s decision in which the court had dismissed the plaintiff’s ERISA excessive fees/breach of fiduciary duty action.

I have practiced law for almost 38 years. The First Circuit’s decision was unquestionably one of the best decisions I have ever read, well-reasoned and well-written. While the decision itself was important, perhaps the most memorable aspect of the decision was the First Circuit’s admonition to 401(k) and, by implication, 403(b) ERISA plans and plan sponsors:

More importantly, the Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.

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.’¹

The First Circuit’s words were reminiscent of a similar warning 40 years earlier by law professor John Langbein, who had served as the Reporter for the committee that drafted the Restatement (Third) Trust:

When market [aka 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 vehicles. 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.²

Where to Now?
Prior to the First Circuit’s Putnam decision several courts had dismissed a number of ERISA excessive fees/breach of fiduciary actions on seemingly questionable grounds, including,

the number of investment options offered by a plan, aka the “menu of options” defense, despite the fact that the Hecker II decision explicitly rejected the “menu of options” defense;³
the argument that certain ranges of fund expense ratios were prudent as a matter of law solely on their own merit, despite the fact that the Restatement (Third) Trusts states that expense ratios are only prudent to the extent that the fund provides a commensurate return for such costs;⁴and
the argument that low-cost Vanguard mutual funds are unacceptable as benchmarks in assessing the prudence of actively managed mutual funds given the difference in the business platforms between the two types of funds, despite the fact that ERISA states that its primary mission is to promote and protect the interests of pension plan participants and their beneficiaries.⁵

The First Circuit’s statement raises a number of questions for ERISA 401(k)/403(b) excessive fees/breach of fiduciary duty litigation going forward. Let’s start at the beginning – Congressional intent.

Congressional Intent
Whenever questions arise about a law, the best place to start is to learn the intent of the body that enacted the law. Since Congress enacted ERISA, the House and Senate reports filed in connection with ERISA should help determine what Congress felt was important about ERISA.

While an exhaustive analysis of ERISA is beyond the scope of this article, a few passages do provide meaningful insight. From House Report No. 93-533 and Senate Report No. 93-127:

The fiduciary responsibility section, in essence, codifies and makes applicable to these fiduciaries certain principles developed in the evolution of the law of trusts….It is expected that courts will interpret the prudent man rule and other fiduciary standards bearing in mind the special nature and purposes of employee benefits plans intended to be effectuated by the Act.⁶

Common Law of Trusts and the Restatement (Third) Trusts
Congress’ specific reference to the common law of trusts, specifically the prudent man rule, raises the importance of the Restatement (Third) Trust (Restatement). The United States Supreme Court has recognized the Restatement as a source that the legal system refers to in answering fiduciary questions, especially questions involving ERISA.⁷

The Restatement sets out the common law of trusts, including the Prudent Investor Rule.⁸The Prudent Investor Rule establishes the general standards for prudent fiduciary investing.

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

A fiduciary has a duty to be cost-conscious. (cmt. a)
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 are imprudent. (cmt. h(2).⁹

Comment f – Reasonableness of Fees
An ERISA fiduciary’s duty to be cost-conscious would impact a popular defense often asserted by plans, plan sponsors and the courts-ERISA does not require that a plan choose the least expensive funds for a plan. However, the lack of any such specific requirement is not necessarily dispositive of the question.

The common law of trusts ‘offers a starting point for analysis of ERISA…. ¹⁰

[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.”¹¹

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….¹²

As a result of these court decisions, a good faith argument can be made that plan sponsors and other plan fiduciaries do not have carte blanche power in approving funds’ fees, but that funds chosen for a plan must satisfy the conditions set forth in comment f of the Prudent Investor Rule.

Comment h(2) – Cost-Efficiency
Plan sponsors, investment fiduciaries and mutual funds do not like to discuss cost-efficiency or the related issue of “closet indexing.”

Restatement Section 90, comment h(2) actually asks whether an actively managed fund is able to cover the additional costs and risk associated with actively managed mutual funds. Research has consistently found that the majority of actively managed mutual funds do not cover their costs.

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.¹³

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.¹⁴

[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.¹⁵

These findings suggest that a plan sponsor faces a difficult task in satisfying ERISA’s duty of prudence requirements, namely

to act ‘with the care, skill prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use’ and ‘with single-minded devotion’ to these plan participants and beneficiaries. ¹⁶

Anyone who practices in the ERISA arena should time the time to review the Enron court’s excellent in-depth analysis of ERISA. In addressing compliance with ERISA’s duty of prudence, the court pointed out that

[a]ccording to the Department of Labor , 29 C.F.R. § 2550.404a-1(b), those requirements are satisfied if the fiduciary

1. Has given appropriate consideration to those facts and circumstances that, given the scope of such fiduciary’s investment duties, the fiduciary knows or should know are relevant to the to the particular investment or investment course of action involved (emphasis added)…; and
2. Has acted accordingly.

‘Appropriate consideration’ for purposes of this regulation includes but is not limited to

A determination by the fiduciary that the particular investment or investment course of action is reasonable designed, as part of the portfolio…to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action….¹⁷

Not to be overlooked that there are different prudence standards for defined benefit and defined contribution plans. Prudence of investments in defined benefit plans is viewed in terms of “the portfolio as a whole,” However, due to the fact that plan participants in defined contribution carry the risk of investment loss, each individual investment in a defined contribution plan must qualify as prudent.¹⁸

The courts have weighed in on the standards for determining compliance with ERISA’s prudence man standard, stating that

[c]ourts] 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. [ERISA’s] test of prudence …is one of conduct, and not a test of performance of the investment. Thus, the appropriate inquiry is ‘whether the individual trustees, at the time they engaged in the challenged transactions, employed the appropriate methods to investigate the merits of the investment and to structure the investment.¹⁹

Not to be overlooked is the Enron court’s reminder that the prudent man standard is “an objective standard and good faith is not a defense to a claim of imprudence.”²⁰

Given the Restatement’s requirement regarding the cost-efficiency of a plan’s mutual fund options and the obvious harm that could result from choosing cost-inefficient investments, the failure of a plan sponsor to verify the cost-efficiency of a plan’s investment options could have severe consequences under the ERISA’s “knew or should have known” standard.

The Active Management Value Ratio™ 3.0 Metric
Recognizing the importance of cost-efficiency in complying with ERISA and the Restatement’s Prudent Investor Rule, I developed a metric, the Actively Managed Value Ratio™ 3.0 (AMVR). The AMVR is a free metric that allows plan sponsors, investment fiduciaries, investors and attorneys to simply and quickly determine the cost-efficiency of an actively managed mutual fund.

The AMVR is the combination of several ideas and findings of some of the most respected experts in the area of investing and wealth management, including the late Vanguard legend John Bogle, Charles D. Ellis, Burton M. Malkiel, Mark Carhart, Roger Edelen and Ross Miller. Anyone with a basic understanding of the basic My Dear Aunt Sally math skills we learned in elementary school (multiplication, division, addition and subtraction) can perform the AMVR calculations. For further information about the AMVR and its calculation process click here and here.

At the end of each calendar quarter, I use the AMVR to do a cost-efficiency analysis in the top ten non-index funds from “Pensions and Investments” top 100 mutual funds in U.S. defined contribution plans. The results are always interesting. The results of the analysis for 3Q 2018 are available here.

Going Forward
As I have read some of the recent court decisions dismissing ERISA excessive fees/breach of fiduciary duty actions, it seems to me that too much attention is being directed toward collateral issues rather than ERISA’s primary purpose-promoting and protecting the best interests of plan participants and their beneficiaries. Making cost-efficiency the primary focus in plans would hopefully avoid litigation altogether or, if litigation is unavoidable, reduce the costs of litigation by simplifying the issues in the action.

I believe the three comments from the Restatement’s Prudent Investor Rule could be effectively used to create legitimate questions of fact, thereby reducing or eliminating dismissals of excessive fees/breach of fiduciary duties actions. By combining the Congressional intent points, related court decisions, and the Prudent Investor Rule standards discussed herein, I believe that proactive plan sponsors can avoid unnecessary and unwanted liability for both themselves and the plan.

The First Circuit has laid down the gauntlet for plan sponsors, investment fiduciaries and ERISA attorneys. The issues, as well as the solutions, are obvious and available. During my closing arguments at trial, I liked to leave the jury with a quote from the late General Norman Schwarzkopf

The truth of the matter is that you always know the right thing to do. The hard part is doing it.

The First Circuit seems to agree with General Schwarzkopf.

Notes

1.Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018)
2. 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
3. Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009) (Hecker II).
4. Restatement (Third) Trust, Section 90, cmt. h(2). (American Law Institute)
5. Brotherston.
6. H. R. Rep. No. 93-533, at 11; S. Rep. no. 93-127, at 29 (1973).
7. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
8. Restatement (Third) Trusts, Section 90. (American Law Institute)
9.Restatement (Third) Trust, Section 90, cmt. a, f, and h(2). (American Law Institute)
10. In re Enron Corp. Securities, Derivatives, and “ERISA” Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003) (Enron).
11. Enron, 546.
12. Enron, 546.
13. 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
14. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
15. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
16. 29 U.S.C. § 1104(a)(1)(B).
17. Enron, 547.
18. DiFelice v. U.S. Airways, 497 F.3d 410, 423, fn. 8 (4th Cir.)
19. Enron, 548.
20. Enron, 548.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investment analysis tools, pension plans, prudence, retirement plans, risk management, wealth management, wealth preservation | 1 Comment

Evaluating Judicial Dismissals of 401(k)/403(b) Fiduciary Breach Actions

Posted on February 5, 2019 by jwatkins

Recently, there have been a number of court decisions dismissing 401(k)/403(b) ERISA breach of fiduciary actions. I have to admit, I am still puzzled by some of the decisions, as the rationales cited by some of the courts seems to be inconsistent with long-standing ERISA precedent.

Whenever I read an ERISA decision, the first thing I look for are the “usual suspects.” As soon as I see these cases cited by a lower court, I immediately question the ability of the lower court’s decision to withstand rigorous appellate review. Some people have said that my “usual suspect” checklist helps them evaluate ERISA decisions. With that in mind, here are some of my most common “usual suspects.”

Vanguard Mutual Fund Are Unacceptable Benchmarks
In Shaw v. Delta Air Lines, Inc., the Supreme Court stated that

ERISA is a comprehensive statute designed to promote the interests of employees and their beneficiaries in employee benefit plans.¹

In one recent decision, the court dismissed an ERISA action based the disallowance of the plaintiff’s use of Vanguard for benchmarking purposes. The court cited the fact that Vanguard’s business relies on an “at-cost” business model, while most actively managed mutual funds use a for-profit model, thus putting actively managed funds at a distinct advantage.

However, if the “best interests” of a plan participant are truly the focus under ERISA, then it seems that the fund that provides the best performance for a plan participant, the fund that improves their “retirement readiness,” should be the court’s primary concern rather than the funds’ business model or promoting the interests of actively managed plans.

In Hirshberg & Norris v. SEC, the court dealt with an analogous situation where the appellee essentially argued that the federal securities laws and regulations were enacted to protect broker dealers rather than the investing public. The court quickly rejected the appellant’s argument, stating that

To accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protections of the broker-dealer rather than the protection of the public….On the contrary, it has long been recognized by the federal courts that the investing and usually naïve public needs special protection in this specialized field. We believe that the Securities Act and the Securities Exchange Act were designed to prevent, among other things, just such practices and business methods as have been shown to have been indulged in by the petitioner in this case.²

I Meant Well/I Had Good Intentions
In another recent ERISA action, one of the court’s stated grounds for dismissing the plan participants’ action was the alleged subjective feelings and beliefs of the plan and the members of the plan’s investment committee. However, as the courts have consistently stated, subjective opinions and beliefs are totally irrelevant in deciding ERISA cases involving alleged breaches of one’s fiduciary duties.

Contrary to the appellee’s contentions, this is not a search for subjective good faith – a pure heart and an empty head are not enough. The statutory reference to good faith in [ERISA] Section 3(18) must be read in light of the overriding duties of Section 404.³

As I often explain to people, there are no mulligans in ERISA. When it comes to ERISA fiduciary law, in the words of that great philosopher, Yoda, “do or don’t do; there is no try.”

And yet, we are seeing cases where a court is seemingly attempting to rationalizing an obvious violation of ERISA on some version of the “pure heart, empty head” defense.

Hundreds of Investment Options = No Fiduciary Breach
A common rationale given by the courts for dismissing ERISA actions is the number of investment options offered by a plan. The court’s reasoning seems to be that the more investment options offered by a plan, the less likely they can be deemed to have breached their fiduciary duty of prudence. This is commonly referred to as the ”menu of options” defense. Most courts attempt to justify this opinion based on the Hecker v. Deere & Co. decision. (Hecker I)⁴

What the courts relying on the “menu of options” defense seem to forget is that the Hecker I decision caused such an uproar that the Seventh Circuit quickly went back and issued a “clarification” of their decision in Hecker II.⁵ In Hecker II, the court made it clear that offering a large number of investment options within a 401(k)/403(b) defined contribution plan does not insulate the plan or the plan’s fiduciaries from liability for the imprudent selection of a plan’s investment options.

As the Sixth Circuit noted in properly nullifying the “menu of options” defense,

Such a rule would improperly shift the duty of prudence to monitor the menu of plan investments to plan participants. The Seventh Circuit opined that such a standard ‘would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives’…[T]he fact remains, ERISA charges fiduciaries like [plan sponsors and other plan fiduciaries] with ‘the highest duty known to law,’ which includes the duty to prudently select investment options and the duty to act in the best interests of the plans.

Much as one bad apple spoils the bunch, the fiduciary’s designation of a single imprudent investment offered as a part of an otherwise prudent menu of investment choices amounts to a breach of fiduciary duty, both the duty to act as a prudent person would in a similar situation with single-minded devotion to the plan participants and beneficiaries, as well as the duty to act for the exclusive purpose of providing benefits to plan participants and beneficiaries.⁶

Attorneys are not supposed to mislead the courts as to applicable legal precedent, for good reason. So given the Seventh Circuit’s “clarification” in Hecker II, one has to wonder why the a court would attempt to rely on Hecker I and the “menu of options” defense without even mentioning the decision in Hecker II, when various federal appellate courts, and even the Hecker court itself, have effectively nullified the defense. There are those that argue that Hecker II was a clarification, not a reversal. Some ERISA attorneys would respectfully beg to differ.⁷If it walks like a duck and quacks like a duck….

Interestingly enough, plans sponsors actually increase their potential for breaching their fiduciary duties by offering more investment options within their plan. In defined benefit plans, the plan retains the risk of loss. In defined contribution plans, the plan sponsor selects the plan’s investment options, but the plan participant bears the risk of investment loss. Therefore,

Under ERISA, the prudence of investments or classes of investments offered by a plan must be judged individually….That is, a fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to plan participants. Here the relevant “portfolio” that must be prudent is each available Fund considered on its own, including the Company Fund, not the full menu of Plan funds.⁸

Therefore, the greater the number of investment options a plan sponsor offers within an ERISA defined contribution plan, the greater the plan sponsor’s potential liability.

The Reasonableness of Mutual Funds’ Expense Ratios Is a Question of Law
Several courts have recently dismissed ERISA actions on the grounds that the expense ratios of the funds involved were appropriate as a matter of law. The “question of law” or “question of fact” is very important, as questions of fact are generally the exclusive province of a jury. Therefore, judges are generally not allowed to dismiss an action if there are genuine questions of fact remaining in an action.

One court addressed the issue by properly pointing out that neither fund fees nor fund performance can be evaluated “in a vacuum.” Then the court went and did just that. To suggest that a mutual fund’s expense ratio can be deemed acceptable, much less a matter of law, based on an expense ratio alone is puzzling.

In Tibble v. Edison Int’l,⁹SCOTUS acknowledged that the courts often turn to the Restatement (Third) of Trusts (Restatement) to resolve fiduciary questions, especially those involving ERISA. Three comments in Section 90 of the Restatement are especially relevant with regard to the issues of the appropriateness of a fund’s expense ratio:

A fiduciary has a duty to be cost-conscious. (cmt. a)
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 are imprudent. (cmt. h(2))¹⁰

Comment h(2) would seem to suggest that in evaluating an actively managed fund’s fees, it must be determined whether the fund provides an investor with a commensurate level of return for the extra costs and risks associated with the fund. None of the decisions involving the idea of expense ratios acceptable as a matter of law mentioned whether the 401(k)/403(b) plans considered the cost-efficiency requirement established under the Restatement’s Section 90, comment h(2) requirement.

“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.” ¹¹

“[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.¹²

[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.¹³

Pension plans, investment fiduciaries and mutual funds do not want to discuss cost-efficiency. They know that the overwhelming majority of actively managed mutual funds are not cost-efficient in their current form and likely never will be given their very nature.

As of February 3, 2019, the Morningstar Investment Research Center was reporting that the average expense ratio for domestic large cap growth funds was 1.10%, with an average turnover ratio of 61% and a 5-year annual return of 7.75. Meanwhile, the average expense ratio for an acceptable large cap growth benchmark, the Admiral shares of the Vanguard Growth Index Fund (VIGAX), was 0.05%, with an average turnover ratio of 8% and a 5-year annualized return of 9.00%.

Using John Bogle’s “all-in” expenses concept¹⁴, the actively managed fund would have to cover approximately 178 basis points just to break even, assuming the actively managed fund managed to even outperform the index fund. In this case, the actively managed fund failed to do so, underperforming the index fund by 1.25%. Given the fact that many funds, especially domestic large cap fund, have increasingly shown a high R-squared, or correlation of returns, number, that hurdle could be significantly more difficult.

The higher costs, both expense ratios and trading costs, make it unlikely that an actively managed fund can meet the standard establish by comment h(2) of the Restatement’s Section 90. I created a simple metric, the Active Management Value Ratio™ 3.0 (AMVR), to help investors, plan sponsors and investment fiduciaries analyze the cost-efficiency of actively managed mutual funds. For more information about the AMVR and the calculation process, click here.

Investment icon Charles D. Ellis has also pointed that a mutual fund’s stated expense is highly misleading. Since an investment manager or mutual fund plays no part in creating the initial assets brought into an account, Ellis properly suggests that the effective expense ratio for an asset manager of a mutual fund should be expressed in terms of the fund’s costs relative to its performance. As an example, Ellis cites a fund with a stated expense ratio of 1% of assets under management. If the fund produces an actual return of 8%, then the effective expense ratio would be more properly seen as 12.5% (1/7).¹⁵

401k and 403b plans that continue to select actively managed funds for their plans face an admittedly difficult challenge. However, the courts have an obligation to enforce the applicable law, including appropriate precedents. In too many cases, an argument can be made that the courts are not doing that.

In perhaps a message to other plan fiduciaries and other courts, in their recent Putnam decision, the First Circuit Court of Appeals stated that

More importantly, the Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.

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.’¹⁶

John Langbein was the reporter for the committee that wrote the current Restatement (Third) of Trusts. Over forty years ago he co-wrote an article predicting the potential impact of the Restatement.

When market [aka 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 vehicles. 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. ¹⁷

Based upon its opinion in the Putnam decision, the First Circuit Court of Appeals appears to believe that that day is here.

Notes

Shaw v. Delta Airlines, Inc., 463 U.S. 85, 90, 103 S. Ct. 2890, 77 L. Ed. 2d 490 (1983).
Hirshberg & Norris v. SEC, 177 F.2d 228, 233 (1949)
Donovan v. Bierwirth, 716 F.2d 1455, 1467 (5th Cir. 1983).
Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009) (Hecker I)
Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009) (Hecker II)
Pfeil v. State Street Bank & Trust Company, 671 F.3d 585, 587, 597-98 (6th Cir. 2012).
Fred Reish, “Hecker v. Deere Revisited,” available online at https://www.drinkerbiddle.com/insights/publications/2009/09/hecker-vs-deere-revisited.
DiFelice v. U.S. Airways, 497 F.3d 410, 423, fn. 8 (4th Cir.)
Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
Restatement (Third) Trusts, Section 90, cmt. h(2)
Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www..ft.con/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e
Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
Available online at http://www.johnbogle.com
Charles D. Ellis,“Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (McGraw-Hill Education: New York, NY), 2018, 163-164.
Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018)
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.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investment analysis tools, pension plans, prudence, retirement plans, wealth management, wealth preservation | Leave a comment

The Georgetown University 403(b) Decision and the Future of 403(b) Fiduciary Litigation

Posted on January 16, 2019 by jwatkins

The recent dismissal of the Georgetown University 403b excessive fees/breach of fiduciary action has led some to suggest that such actions are now over. A closer look at the Georgetown decision suggests that that opinion may be premature.

I always read every decision in 401(k)/403(b) excessive fees/breach of fiduciary actions. As I read Judge Collyer’s decision, I understood and agreed with her Honor’s reasoning…until I came to her analysis of the CREF Stock fund (Stock fund).

In almost every 403(b) excessive fees/breach of fiduciary action, the Stock fund and the TIAA Real Estate Fund have been the target of the plaintiffs’ breach of fiduciary/ prudence claims. For the purposes of this article, I want to focus solely on the Stock fund

The Court’s Analysis of the CREF Stock Fund R3 (QCSTIX)
As I read the Court’s analysis of the Stock fund, one statement in particular immediately caught my attention.

Notably, the independent analyst Morningstar rated the CREF Stock Account as a 5-start (sic) investment option, which also counters plaintiffs’ allegations of imprudence.

With all due respect to the Court and her Honor, I do not, and cannot, agree with that conclusion. Based on the nature of the arguments within the Court’s analysis of the Stock fund, the Court based its opinion purely on the fund’s returns, both the fund’s nominal, or stated, and risk-adjusted returns.

For the courts to start basing decisions even in part on Morningstar’ “star” system is not a good sign. Morningstar has stated that their star system is based largely on a fund’s risk-adjusted return. There is no indication that they consider other key factors, such as cost-efficiency or possible “closet indexing.”

Information from the web sites of both Morningstar (morningstar.com) and Financial Times (www.ft.com) arguably disproves every point cited in the Court’s Stock fund analysis. For instance, the court stated that the Stock fund had consistently outperformed its benchmarks. However, a chart comparing the Stock fund to admiral shares of the Vanguard Growth Index Fund (Vanguard fund), a comparable index fund with actual costs, seems to indicate that the Stock fund has consistently underperformed the less expensive Vanguard fund. (https://markets.ft.com/data/fund/tearsheets/charts?s=QCSTIX)

In fairness to the Court, it appears that the Court’s analysis was based on two benchmarks designated by the Stock fund, two market indices, not on the Vanguard fund.

But why?

Plan sponsors are unquestionably fiduciaries under the law. SCOTUS has endorsed the Restatement (Third) Trusts (Restatement) as a legitimate resource in resolving fiduciary issues, especially fiduciary issues involving ERISA.¹

ERISA imposes a fiduciary duty of prudence on plan sponsors and other plan fiduciaries. Section 90 of the Restatement, otherwise known as the Prudent Investor Rule, establishes various standards for questions involving fiduciary prudence. Three such standards stand out:

A fiduciary has a duty to be cost-conscious.²
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.³
Actively managed mutual funds that are not cost-efficient are imprudent.⁴

Comment h(2) is particularly interesting. Numerous studies have shown that the overwhelming majority of actively managed funds are not cost-efficient.⁵In fact, one study concluded that the majority of actively managed mutual funds fail to even cover their costs.⁶ Since most 401(k) and 403(b) plans still primarily choose actively managed mutual funds, these studies should be strongly considered by plan sponsors and other plan fiduciaries, such as a plan’s investment committee. This is even more noteworthy since most plan advisory contracts include language insulating the plan service provider from any liability in connection with the advice provided to the plan.

So the Restatement establishes cost-efficiency as a factor in evaluating the prudence of a plan sponsor or any other plan fiduciary. Yet, for some reason, you rarely see cost-efficiency plead in ERISA plaintiffs’ complaints or addressed by the courts in dismissing 401(k) and 403(b) breach of fiduciary actions.

I would suggest that cost-efficiency provides a much better indication of a fund’s prudence, as cost-efficiency

Can eliminate the argument over what constitutes an acceptable benchmark by using comparable index funds that actually incur costs;
Provides a truer evaluation of the inherent value of a fund and reduces the problem of misleading results based solely on a fund’s returns;
Can help identify and avoid “closet index” funds, thereby improving an investor’s return

Recognizing the Restatement’s standards regarding the importance of cost-efficiency in potential breach of fiduciary duty cases. I created a simple metric, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is a simple, straightforward metric that allows investors, plan sponsors, investment fiduciaries and attorneys to determine the cost-efficiency of actively managed mutual funds, or simply two mutual funds. The metric is free and only requires the ability to perform the basic My Dear Aunt Sally (multiplication, division, addition, subtraction) math skills we all learned in elementary school.

AMVR Cost-Efficiency Analysis of CREF Stock Account R3

I do not know what the actual data was that was presented to and used by the Court in deciding the Georgetown action. As I mentioned earlier, I am relying on information that I obtained from the Morningstar and Financial Times web sites. The data is based on the recent five-year performance of both funds as of December 31, 2018.

As I mentioned earlier, a chart from the Financial Times web site comparing the Stock fund (QCSTIX) to the Vanguard Growth fund (VIGAX) clearly shows that the Vanguard fund has consistently outperformed the Stock fund since the Stock fund’s inception. The AMVR cost-efficiency analysis further supports the argument that the Vanguard fund is a more prudent investment option for fiduciaries.

The first step in an AMVR analysis is to determine whether the actively managed fund, or simply the fund being considered, managed to produce a positive incremental return relative to a comparable index fund. Here, the Stock fund has not only underperformed the Vanguard fund, but by a large margin, 525 basis points. That alone establishes that the Stock fund is an imprudent selection by a fiduciary.

Second, the AMVR uses the three largest fees/costs associated by a mutual fund: the fund’s annual expense ratio, the fund’s turnover (aka trading costs), and any 12b-1 fees imposed by a fund. The AMVR’s inclusion of a fund’s annual expense ratio and trading costs in calculating a fund’s costs is based upon the research of respected academics such as Burton Malkiel and Mark Carhart, both of whom found that those two costs were the two most reliable predictors of a fund’s future performance.⁷

Since actual trading costs are difficult to obtain, the AMVR uses a metric created by John Bogle. While Bogle’s metric probably understates a fund’s actual trading costs, it provides a proxy for such costs. Since a fund’s trading costs are often larger than a fund’s annual expense ratio, such costs potentially have too much of an impact on a fund’s cost-efficiency and overall performance to simply be ignored.

The AMVR calculates a fund’s cost-efficiency rating on both a fund’s reported costs and a fund’s R-squared rating. The R-squared metric measures the extent to which a fund tracks a comparable market index or a comparable index fund. The R-squared metric helps to detect a “closet index” or “index hugger” fund. Closet index funds are actively managed funds that essentially provide the same performance of a comparable index fund, but charge a much higher fee. They are cost-inefficient, and thus imprudent investment choices, by their very nature.

In this case, the reported costs are 96 basis points higher than the index fund’s fees. As a result, the Stock fund’s incremental, or extra, costs constitute 86 percent of the Stock fund’s total costs, while providing no incremental return, or benefit, to an investor at all.

The AMVR uses the Active Expense Ratio (AER) to calculate a fund’s effective annual expense ratio. The AER was created by Professor Ross M. Miller. The AER uses a fund’s R-squared number, or correlation of returns, to calculate the effective annual expense ratio that investors in the fund pay. The higher a fund’s incremental costs and/or R-squared number, the higher the fund’s AER. Professor Miller found that investors often pay effective expense ratios that are 6-7 higher than the fund’s stated expense ratio.

In this case, the Stock fund had an R-squared number of 97, suggesting an extremely high correlation of returns between the Stock fund and the Admiral shares of Vanguard Growth Index fund. The high R-squared number, combined with the Stock fund’s high incremental costs, resulted in an effective annual expense ratio of 5.13. Substituting the fund’s AER for the lower stated expense ratio resulted in the fund’s costs constituting 97 percent of the fund’s total cost, again with no incremental return, or benefit.

It would be hard to legitimately argue that the Stock fund is prudent in either scenario. This is supported by the comparison chart available on the Financial Times site. The comparison chart essentially confirms that the Stock fund is a “closet index” fund, with virtual identical returns of the Vanguard fund, lowered by the Sock fund’s higher fees/costs.

The Future of 403(b) Fiduciary Litigation
So, is it reasonable to predict that the Georgetown decision and other similar 403(b) dismissal decisions are indications that 403(b) breach of fiduciary actions will decline? No one knows for sure, but if plaintiffs’ ERISA attorneys tweak their complaints to include claims based on cost-efficiency and “closet index” issues, I see no reason for such actions to decline.

Judges are only allowed to determine questions of law. Questions of fact are the exclusive province of the jury. Questions involving cost-efficiency and/or “closet indexing” are clearly questions of fact. As a result, incorporating those two issues in an action could reduce the number of early dismissals.

Funds that are not cost-efficient means that investors in such funds effectively suffer a net loss on their investments. The AMVR not only identifies funds that are not cost-efficient, but helps define the damages resulting from a fund’s lack of cost-efficiency.

Most funds focus on returns, specifically nominal, or stated, returns. Funds try to avoid discussing load-adjusted and risk-adjusted returns since they usually reduce an actively managed fund’s return, thereby favoring index funds.

Most funds and stockbrokers want to avoid any discussion of the cost-efficiency of actively managed mutual funds, as funds know that they usually will lose that argument due to the high fees commonly associated with such funds. Most funds and stockbrokers also want to avoid any discussion of “closet indexing,” as many actively funds have made a conscious decision to closely track the performance of comparable indices and index funds in order to avoid significant variances in performance, which could result in customers leaving in favor of comparable, but less expensive, index funds.

On the other hand, those are precisely the reasons plaintiff’s ERISA attorneys may choose to tweak their pleadings to include claims relative to cost-efficiency and “closet indexing.” As mentioned earlier, focusing on those two issues would create questions of fact, which judges are not allowed to decide. As a result, arguments based on cost-efficiency and “closet indexing could effectively reduce the number of pre-trial dismissals of 403(b) breach of fiduciary duty actions.

Conclusion
I am an unabashed fan of Sun Tzu’s “The Art of War.” Three quotes from the book stand out to me in terms of any type of litigation:

If you know the enemy and you know yourself, you need not fear the result of a hundred battles….

To secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself.

He who is prudent and lies in wait for an enemy, who is not, will be victorious.

The evidence overwhelmingly supports the argument that most current actively managed funds are not cost-efficient. Could they become cost-efficient and reduce fiduciaries’ liability exposure? Absolutely. Are they likely to reduce their costs in order to become cost-efficient? Not likely. But that’s just my opinion.

Until then, prudent plan sponsors and investment fiduciaries will evaluate existing and potential plan investment options on both risk-adjusted returns and cost-efficiency, including potential “closet indexing” issues. Prudent plaintiff’s attorney will do likewise in order to reduce the odds of dismissal and maximizing their action’s potential damages.

2019 could turn out to a pivotal year in the future of ERISA litigation.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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.

Notes
1. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
2. Restatement (Third) Trusts, Section 90, comment b.
3. Restatement (Third) Trusts, Section 90, comment f.
4. Restatement (Third) Trusts, Section 90, comment h(2).
5. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e; Carhart, Mark, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82; Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” available at http://www.ssrn.com/ abstract=951367
6. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.
7. Carhart, supra; Malkiel, Burton, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.

Posted in 403b, closet index funds, consumer protection, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investments, pension plans, prudence, wealth management, wealth preservation | Tagged 403b, Active Management Value Ratio, AMVR, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investment analysis tools, pension plans, prudence, wealth management, wealth preservation | Leave a comment