“Whoa Nelly”*-Reg BI and That Other “F” Word

Posted on May 7, 2019 by jwatkins

*Yes, I am old, Yes, I used to love listening to the late Keith Jackson call college football games. I miss his “whoa Nelly” calls.

As the debate over the SEC’s proposed Regulation Best Interest (Reg BI) rages on, people have increasingly asked me what I think will happen. The SEC is obviously going to propose Reg BI in some form. I expect various legal actions to be filed attempting to stop the implementation. In the end. I expect at least one court to rule that Reg BI violates the SEC’s express mission statement, to protect and promote investors’ interests, and is therefore unenforceable. Just my opinion.

Lot of moving parts behind that opinion, but all supported by existing law. First, the SEC’s stated purpose is to enact rules and regulations that protect investors, not broker-dealers. Reg BI adopts a number of positions that arguably advance the interests of broker-dealers and their representatives at the cost of investors.

The clearest example of this is Reg BI’s adoption of a disclosure rule regarding conflicts of interest rather than a strong absolute prohibition of selling when conflicts of interest exist. Making matters even worse is the failure of the SEC to offer and require a clear and understandable standardized format for such disclosures of conflicts of interests.

Another obvious problem with Reg BI is the SEC’s to define the core concept, best interests. While one could argue that such an oversight was deliberate to further protect the investment industry, I would suggest that there are two potential ways that investors may be able to overcome such tactics.

At least for the present time, FINRA’s rules would still apply. Often overlooked is FINRA’s requirement with regard to the other “F” word-“fair dealing.” Fortunately, NASD/FINRA and SEC enforcement decisions provide valuable guidance in defining fair dealing and what constitutes a violation of the requirement.

The Scott Epstein enforcement decision (Exchange Act Release No. 34-59328) is the decision most cited in connection with FINRA’s fair trading/fair treatment requirement (FINRA Rule 2111, Supplementary Material -.01). The panel noted that FINRA and the SEC have consistently stated that a registered representative’s “recommendations must be consistent with his customer’s best interests.”

Implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of FINRA rules, with particular emphasis on the requirement to deal fairly with the public. The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.

OK, so we have the rule. But what does it mean and what constitutes a “fair dealing” violation by a broker-dealer or stockbroker? Epstein was accused of engaging in “switching,” or recommending the sale and subsequent purchases of mutual funds for the primary purpose of generating commissions for him and his broker-dealer. In ruling that Epstein was guilty of all charges, the SEC panel justified its decision by stating that

Epstein’s recommendations served his own interests by generating substantial production credits, but did not serve the interests of his customers. Epstein abdicated his responsibility for fair dealing when he put his own self-interest ahead of the interests of his customers.

So, the fair dealing requirement incorporates the same “best interest” standard, one based on broker/adviser’s putting his/her financial interests ahead of the customer’s financial interests. Seems simple enough, but how would one prove this.

Anyone who follows me on social media or on one of my blogs knows that I am a staunch advocate of using cost-efficiency to prove securities violations involving fair dealing, suitability and/or a duty of prudence. After all, Sections 90 of the Restatement (Third) of Trusts, otherwise known as the Prudent Investor Rule, establishes several prudence standards.

Since broker-dealers and stockbrokers often recommend actively managed funds, the key comment to Section 90 is comment h(2), which essentially states that recommending or using actively managed mutual funds is imprudent unless the funds are cost-efficient, that is their anticipated returns cover the fund’s extra costs and risks. As the Comment to Section 7 of the Uniform Prudent Investor Act states, “wasting beneficiaries’ money is imprudent.”

Based on the research of numerous noted and well-respected investment experts, the evidence overwhelmingly states 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

This would certainly seem to make the justification of a recommendation of an actively managed mutual fund more questionable unless the financial adviser can show that the fund(s) in question are cost-efficient relative to other comparable investment options, including comparable index funds.

There are those that suggest that comparing actively managed funds to less expensive index funds is inherently unfair. However, if we accept that the guiding principle is the protection of investors and putting their financial best interests first, then the only thing that matters is the comparative cost-efficiency of the funds under consideration.

The concept of comparing actively managed funds to comparable index funds has the support of two well-respected investment icons, Nobel Laureate William S. Sharpe and Charles D. Ellis.

‘[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’5

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!6

By adopting cost-efficiency as the preliminary and primary standard in addressing both FINRA’s fair trading rule and the prudence under Reg BI’s duty of care, the court and the parties would only have to answer one simple two-part question:

At the time that the financial adviser selected a particular actively managed fund to recommend:
(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 the SEC mission statement of properly protecting investors’ best interests?”

If an actively managed fund is cost-inefficient relative to a comparable index fund, or if a comparable index fund was not even considered, I am not sure how one can argue in good faith that the actively managed fund is in any customer’s best interests  Since financial advisers typically receive commissions in connection with sales of actively managed funds, you would be looking at an Epstein-like situation, where the financial adviser would profit financially, while the customer would actually be losing money relative to comparable cost-efficient investment options.

At the end of the day, we hold these truths to be self-evident:

  1. prudent investors do not knowingly invest in cost-inefficient investments, and
  2. recommending cost-inefficient investments to customers is not fair dealing/fair treatment.

Going Forward
As I stated earlier, if the SEC adopts Reg BI as currently written, I do not believe that it will withstand judicial scrutiny. The obvious issue that I would expect opponents of Reg BI to address is why the SEC did not just adopt the fiduciary standard set out in the Investment Advisor Act of 1940. I would provide the protection investors need and provide one uniform standard.

The SEC has tried to justify the adoption of a much lenient suitability standard on the grounds of wanting to provide investors with a choice of how they receive investment advice. With all due respect, that argument is simply “disingenuous double talk.” If I was a judge in any of these cases challenging Reg BI, I would quickly point out to the counsel that the choice of a standard of prudence in no way prohibits the business model chosen by the investment industry. It simply requires a certain level of conduct from broker-dealers and financial advisers in carrying out their business model.

The SEC’s mission statement makes their primary mission the protection of investors. In opting for a suitability standard, the SEC has deliberately chosen the weaker of two options. Again, if I were a judge hearing one of the promised challenges to Reg BI, I am asking the SEC why the less protective suitability standard was really chosen, as it definitely seems to favor the investment industry at the expense of public investors.

Another issue that I would address is the noticeable absence of any express fair dealing require such as set out in FINRA’s rules. The SEC would probably answer that such a requirement is implicit in the definition of “best interests,” but then again that should raised the issue of why Reg BI does not define “best interest” at all.

The absence of an express fair dealing requirement in Reg BI is also troubling given FINRA’s statement that it might just adopt Reg BI as well. What is unclear is whether that FINRA would eliminate its express fair dealing requirement as part of such a move, arguably eliminating a key investor protection measure.

If Reg BI were to survive all legal challenges, the question would be whether the plaintiff’s bar would argue fair dealing and prudence based upon a cost-efficient standard. Given the evidence cited herein, the adoption of such a standard would seemingly simplify the argument of such legal actions. The only question would be whether an actively managed fund’s incremental costs exceed the fund’s incremental returns relative to a comparable index fund. The strategy would also seemingly impose an extremely difficult evidentiary burden on the investment industry, given the extra costs and risks typically associated with actively managed funds relative to index funds.

Chairman Clayton has recently announced that the release of Reg BI may be sooner than later. Actual implementation would obviously be significantly delayed if the promised challenges to Reg BI do occur, especially given the expected appeals by the losing party. Something leads me to believe that these cases are going to be “doozeys” for legal eagles.

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. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm
6. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”                     available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c

© Copyright 2019 The Watkins Law Firm. All rights reserved.

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 AMVR, best interest, consumer protection, cost consciousness, cost efficient, cost-efficiency, fiduciary compliance, prudence, Reg BI, SEC, securities, securities compliance | Tagged , , , , , | Leave a comment

Simple and Sound Advice from Jack Bogle…Again

Posted on May 5, 2019 by jwatkins

Sound advice from Mr. Bogle…again. Several years ago I suggested the concept of EZ 401(k) plans in my book, “What Plan Sponsors and Plan Participants REALLY Need to Know.” ERISA only requires three broadly diversified funds. Following Mr. Bogle’s advice would greatly reduce compliance costs and potential liability exposure for 401(k) and 403(b) plans.

https://www.yahoo.com/finance/news/vanguard-founder-jack-bogle-apos-194408395.html

 

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, cost consciousness, cost efficient, cost-efficiency, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , | Leave a comment

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 , , , , , , , , , , , , , , , , , , , , | 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)

© Copyright 2019 The Watkins Law Firm. All rights reserved.

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 , , , , , , , , , , , , , , , , , , | 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….”3 I 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 (1st 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 , , , , , , , , , , , , , , , , , , | 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.”

© Copyright 2019 The Watkins Law Firm. All rights reserved.

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.

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st 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 , , , , , , , , , , , , , , , | 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 , , , , , , , , , , , , , , , , | 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.

Copyright © 2019 The Watkins Law Firm. All rights reserved.

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 , , , , , , , , , , , , , , , , , , , | 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.

Copyright © 2019 The Watkins Law Firm. All rights reserved.

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. 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 , , , , , , , , , , , , , , , , , , | 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;4 and
  • 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.8 The 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

  1. 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.

Copyright © 2019 The Watkins Law Firm. All rights reserved.

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.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.

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