“Avoiding ‘Lipstick on a Pig’: Evidence-Based Investing for ERISA Fiduciaries”

Posted on March 13, 2018 by jwatkins

“You can put lipstick on a pig, but it’s still a pig.” – Wall Street saying

I often serve as a consultant to securities/ERISA attorneys and 401(k)/403(b) retirement plans. I am often asked to perform a forensic analysis of an investment product or an entire investment portfolio.

In my opinion, the ongoing litigation involving 401(k), 403(b) and other pension plans is simply going to increase due the fact that most plan sponsors and other fiduciaries either do not know how to properly evaluate mutual funds or fail to do so. Based on my experience, far too many plan sponsors simply decide to blindly follow whatever recommendations they receive from plan advisers and other third parties, despite the fact that the courts have consistently warned that to do so is a clear violation of a plan sponsor’s fiduciary duties.(1)

Fred Reish and Bruce Ashton, two noted ERISA lawyers, wrote an excellent article warning ERISA fiduciaries that while full implementation of the DOL’s new rule is still pending, plan advisers are currently subject to the rule’s Impartial Conduct Standards, including the “best interest” standards.(2) While some have complained that some terms, such as “reasonable” and “best interests,” are subjective and have yet to be properly defined, such arguments are without merit.

As the Supreme Court pointed out in their Tibble decision,(3) the courts often look to the Restatement (Third) Trusts (Restatement) for guidance on fiduciary issues, especially those involving ERISA questions. In my practice, I always point clients to two particular sections of the Restatement. Section 88 states that fiduciaries have a duty to be cost conscious. Section 90, known as the Prudent Investor Rule, has numerous key provisions for fiduciaries. I always point to comment h(2) which states that a fiduciary should not utilize actively managed mutual funds unless the fund’s past performance reasonably leads one to assume that the fund’s performance will more than cover the extra costs and risks typically associated with actively managed funds.

Other sections from the Restatement dealing with the importance of the fiduciary duty to be cost include the Introductory Note to Section 90 and Section 90, comments b and m. Comment b to Section 90 sums up the entire issue perfectly, stating that “[C}ost conscious management is fundamental to prudence in the investment function.”

As a securities/ERISA attorney, I put a great deal of emphasis on evidence and evidence-based investing. Since plan sponsors and other investment fiduciaries can expect the same in litigation or an audit, I strongly suggest that they adopt a similar policy.

One source of valuable information is the semi-annual SPIVA (Standard & Poor’s Indices Versus Active) reports.(4) Based on their performance over the five-year period ending June 30, 2017, 82.38 percent of large cap funds, 87.21 percent of midcap funds, and 93.83 percent of small cap funds underperformed their S&P benchmarks. Drilling down further in the large cap sector, the sector that dominates most retirement plans, over the same time period, 76.43 percent of large cap growth, 88.63 percent of large cap value, and 85.09 percent of large cap core funds underperformed their comparable S&P index.

While SPIVA reports provide valuable information for investment fiduciaries, they are based purely on absolute performance and do not factor in such issues as a fund’s cost efficiency and/or the fund’s potential classification as a “closet index” fund. Numerous studies have documented the importance of cost efficiency, particularly with regard to a fund’s expense ratio and trading costs.

“The two variables that that do the best job at predicting future performance [of mutual funds] are expense ratios and turnover.”(5)

“Expense ratios, portfolio turnover, and load fees are significantly and negatively related to [a mutual fund’s performance].”(6)

“[A fund’s) expense ratio and portfolio turnover are negatively associated with investment performance.”(7)

“On average, trading costs negatively impact fund performance….On average, [actively managed funds] fail to fully recover their trading costs-$1 in trading costs reduces fund assets by $0.41….We fund that trading costs have an increasingly detrimental impact on performance….”(8)

Despite this evidence, 401(k) plans and other types of retirement plans have historically chosen actively managed mutual funds as the primary investment options for their plans. While we are seeing a change to the inclusion of more index funds within plans, actively managed funds are still the predominant investment choice in 401(k) plans and other retirement plans.

In order to factor in the cost efficiency and closet index issues, I was asked by some of my litigation clients to create a fiduciary prudence screen that factors in such issues using Morningstar’s Research Center program.  The screen evaluated the universe of actively managed mutual funds based on their Morningstar category, progressively eliminating funds that failed to pass a component of a screening factor. The screening components and the overall findings of the study are attached as Exhibit A. (Note: The apparent discrepancy in the number of funds passing the screens and the specific funds identified is due to the fact that only retirement shares that passed the screens are identified in this exhibit.)

A number of courts have recently ruled in favor of 401(k) plans, causing plans and their attorneys to declare that the tide has turned in favor of plans in excessive fee cases. Some ERISA plaintiff attorneys have suggested that such predictions are premature based on the fact that a number of said courts failed to factor in the Restatement’s cost efficiency mandate and the entire closet index issue.

Some courts seem to have suggested that the sheer number of investment options offered by a 401(k) or other retirement plan insulates a plan from any finding of breach of their fiduciary duties, such opinion apparently being based on the Seventh Circuit’s ruling in Hecker v. Deere, Inc. (Hecker I).(9) However, the Seventh Circuit quickly went back and rejected such a notion in Hecker II(10) in what the court labeled a “clarification,” but most securities and ERISA attorneys agree was a reversal of their earlier decision.

Most of the previously mentioned pro-plan decisions have been appealed for the reasons mentioned herein. It would not be surprising to see the appellate courts reverse the pro-plan decisions and remand the cases back to the lower courts to allow further litigation on the fiduciary issues. In order to prevent such questionable decisions going forward, expect to see the plaintiff’s bar focus additional attention on the issue of a fiduciary’s duty to be cost efficient and the closet index issue, as the evidence overwhelmingly establishes the failure of most actively managed funds to meet such hurdles.

Going Forward
One of my favorite quotes is “facts do not cease to exist because they are ignored.” So, given the evidence discussed herein, what are the potential “best practices” and liability implications for investment fiduciaries?

Fiduciary law and ERISA are essentially codifications of the common law of trusts, agency and equity. Quantum meruit is a basic tenet of equity law.  In the commercial context, quantum meruit essentially says that if one provides compensation to another, whether it be cash or services, the party providing such compensation has a reasonable expectation of receiving something of equal or greater value in return.

The evidence clearly shows that in the investment industry, far too often investors are simply not receiving equal or greater value in exchange for the compensation they are paying investment advisers and mutual fund companies. That fact becomes even clearer if one applies the incremental cost/incremental return analysis developed by Charles D. Ellis.(11)

Combining Ellis’ incremental cost/incremental return approach with Burton Malkiel’s findings regarding the predictive powers of a fund’s expense ratio and trading costs, I created a metric, the Active Management Value Ratio™ (AMVR). The AMVR allows investors and investment fiduciaries to calculate the cost efficiency of an actively managed mutual fund. The AMVR often shows that a specific actively managed mutual fund is not cost efficient, and therefore not a prudent invest choice under the Restatement’s fiduciary standards. For further information on the AMVR and its calculation process, click here.

Based on data from the Morningstar Research Center, as of January 31, 2018, the difference between the expense ratios for Vanguard benchmark funds used in my analysis, VFIAX, VIGAX and VVIAX, and the average expense ratios for the funds in their respective sections is approximately 96 basis points (large cap blend), 105 basis points (large cap growth) and 109 basis points (large cap value). Add in the turnover/t rading costs for all the funds and sectors, and the cost differences rise 105 basis points (large cap blend), 162 basis points (large cap growth), and 159 basis points (large cap value).

Given the evidence that very few actively managed mutual funds manage to even cover their costs, let alone outperform their relative benchmarks at all, it is easy to see why very few actively managed funds are cost efficient. Even when an actively managed fund does manage to outperform its relative bench mark, the difference is usually less than 25-50 basis points, far below the 100+ cost basis points differential indicated in the Morningstar data.

Under both the DOL’s new Impartial Conduct Standards and basic fiduciary law, two key concepts are “reasonable compensation” and the “best interests” of a customer. I believe that the evidence discussed herein, along with the AMVR, create some pivotal questions that investment fiduciaries, both ERISA and non-ERISA, and the courts must address going forward, namely

  • Is any compensation “reasonable” or in the “best interest” of a customer if the historical performance of the recommended investments indicated that such investments were not cost efficient and/or would have failed to provide any inherent value for a customer, i.e, would not have produced a positive incremental return for a customer, at the time the recommendations were made?
  • If the goals of ERISA are to be achieved, protection of plan participants and promotion of their “retirement readiness,” shouldn’t the inherent value of a retirement plan’s investment options in terms of benefits provided, if any, be the key issue rather than the business platform chosen by a mutual fund company?

Conclusion
Existing evidence overwhelmingly establishes the failure of most actively managed mutual funds to meet the fiduciary requirements for loyalty and prudence set out in the Restatement, a resource which the Supreme Court recognized in the Tibble decision. As the plaintiff’s bar devotes more attention to such standards and evidence of non-compliance with same, it would serve plan sponsors and other investment fiduciaries to do so as well.

 Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Notes
1. Gregg v. Transportation Workers of America Int’l, 343 F.3d 833 (2003), Liss v. Smith, 991 F. Supp 278 (S.D.N.Y. 1998)
2. Bruce L. Ashton and Fred Reish, “Under the DOL’s Fiduciary Rule, Beware the Myths,” Employee Benefit Adviser, available online at http://www.employeebenefitadviser.com/opinion/under-the-dols-fiduciary-rule-beware-the-myths
3. Tibble v. Edison International, 135 S. Ct. 1823, 1828 (2015)
4. http://us.spindices.com/spiva/
5. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
6. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
7. Zakri Y. Bello and Lisa C. Frank, “A Re-Examination of the Impact of Expenses on the Performance of Actively Managed Equity Mutual Funds,” European Journal Finance and Banking Research, Vol. 3, No. 3 (2010)
8. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/abstract=951367
9. Hecker v. Deere (Hecker I), 556 F.3d 575 (7th Cir. 2009)
10. Hecker v. Deere (Hecker II), 569 F.3d 708, 711 (7th Cir. 2009)
11. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,”6th ed. (New York, NY: McGraw/Hill, 2018), 10

EXHIBIT A

YrR – Annualized Return
ER – Expense Ratio
TO – Turnover

2018 Morningstar Cost Efficiency and R-squared Analysis
VFIAX LCB/1346 Top Quartile
5 YrR > 118
5 YrR load adj > 95
ER < .50 25 .01-.97
TO < 50 19 0-20
Rsqrd < 90 1 96-100 VFIAX
VIGAX LCG/1352
5 YrR > 400
5 YrR load adj > 332
ER < .50 31 0-.69
TO < 50 27 0-26
Rsqrd < 90 16 89-99 RGAGX, RNGGX, FNCMX, VMRAX, VPMAX, VWUAX
VVIAX LCV/1214
5 YrR > 40
5 YrR load adj > 37
ER < .50 12 .05-.65
TO < 50 6 0-26
Rsqrd < 90 1 90-97 VVIAX
VMGMX MCG/596
5 YrR > 212
5 YrR load adj > 191
ER < .50 4 0-.90
TO < 50 4 0-25
Rsqrd < 90 4 83-89 FMCSX, IRGJX
VMVAX MCV/394
5 YrR > 13
5 YrR load adj > 12
ER < .50 1 0-.77
TO < 50 1 0-32
Rsqrd < 90 1 79-90 VMVAX
VSGAX SCG/776
5 YrR > 179
5 YrR load adj > 169
ER < .50 9 ..06-.92
TO < 50 6 0-35
Rsqrd < 90 6 67-87 DSCGX, ALFYX, VRTGX
VSIAX SCV/399
5 YrR > 20
5 YrRload adj > 15
ER < .50 2 .06-.93
TO < 50 2 0-23
Rsqrd < 90 2 55-68 VSIAX, VSIIX
Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

The Active Management Value Ratio 3.0: Investment Returns and Wealth Preservation for Fiduciaries and Plan Fiduciaries

Posted on January 17, 2018 by jwatkins

Studies have consistently shown that people are more likely to understand and retain information that is conveyed visually rather than verbally or in print. I regularly receive requests for copies of the PowerPoint slides. So for those of you that have never seen one of my presentations on the value of InvestSense’s proprietary metric, the Active Management Value Ratio ™ (AMVR) 3.0, here is a simple explanation of how the AMVR can help you detect cost-inefficient actively managed mutual funds in your personal portfolios and 401(k) plan accounts and better protect your financial security.

The Active Management Value Ratio™ (AMVR) 3.0
Active Management Value Metric (AMVR) 3.0 is based on combining the findings of two prominent investment experts, Charles Ellis and Burton Malkiel, with the prudent investment standards set out in the Restatement (Third) Trusts’ “Prudent Investor Rule.”

[R]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.” – Charles Ellis

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

Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs,…If the extra costs and risks of an investment program are substantial, those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;… – Restatement (Third) Trusts [Section 90 cmt h(2)]

The following slides are based on the returns and risk data, 2017of a popular actively managed mutual fund over the five-year period January 1, 2013 to December 31, 2017, compared to the returns and risk data of a comparable Vanguard index fund. The fund charges a front-end load, or purchase fee, of 5.75 percent. The Vanguard index fund does not charge a front-end load.

Nominal Returns
Mutual funds ads and brokerage accounts often provide a fund’s returns in terms of its nominal, or unadjusted returns. In our example, the actively managed fund’s incremental, or extra, costs exceed the fund’s incremental returns. This would result in a net loss for an investor, making the fund cost-inefficient and a poor investment choice. Furthermore, 67 percent of the actively managed fund’s fee is only producing 1 percent of the actively managed fund’s overall return. Yet another way of looking at the analysis – would you rather pay $31 for 15.92% in returns or $94 for an additional 0.16% of return?


Load-Adjusted Returns
However, Investors who invest in funds that charge a front-end load do not receive a fund’s nominal return since funds immediately deduct the cost of the front-end load at the time of an investor’s purchase of the fund. Since there is less money in the account to start with, an investor naturally receives less cumulative growth in their account when compared to a no-load fund with the same returns. This lag in cumulative growth will continue for as long as they own the mutual fund.

In our example, once the impact of the front-end load is factored into the fund’s returns, the investor not only charges higher fees, but also suffers an opportunity cost, as the fund underperforms the benchmark, the comparable Vanguard index fund. This double loss clearly makes the fund cost-inefficient and a poor investment choice.


Risk-Adjusted Returns
A final factor that should be considered is the risk-adjusted return of a fund. When comparing funds, it is obviously important to know if a fund incurred a higher level of risk to achieve its returns relative to another fund since investors may not be comfortable with such risk. As the quote from the Restatement points out, at the very least, investors would expect a higher return that would compensate them for a higher level of risk.

In our example, the actively managed fund assumed slightly less risk (10.01) than the Vanguard index fund (10.37). As a result, the actively managed fund’s returned improved slightly, but the fund failed to provide a positive incremental return and the fund’s incremental costs exceeded the fund’s incremental return. Once again, this double whammy makes the fund cost-inefficient and a poor investment choice.

The investment industry will often downplay unfavorable risk-adjusted results, saying that “investors cannot eat risk-adjusted returns.” However, the combined impact of additional fees and under-performance should not be ignored by an investor. Each additional 1 percent in fees results in approximately a 17 percent loss in end return for an investor over a twenty-year period. Historical under=performance can be considered an additional cost in evaluating a fund’s cost-efficiency since investor’s invest to make positive returns and enjoy the benefits of compounding of returns.

Interestingly enough, funds that may criticize risk-adjusted performance numbers have no problem touting favorable “star” ratings from Morningstar, which bases its “star” rating on, you guessed it, a fund’s risk-adjusted returns.

In my legal and consulting practices, we add two additional screens. The first screen is designed to eliminate “closet index” funds. Closet index funds are actively managed mutual funds that essentially track a market index or comparable index fund, but charge fees significantly higher, often 300-400 percent or higher, than a comparable index fund. Consequently, closet index funds are never cost-efficient.

The second additional screen InvestSense runs is a proprietary metric known as the InvestSense Fiduciary Rating (IFR). The IFR evaluates an actively managed mutual fund’s efficiency, both in terms of cost and risk management, and consistency of performance.

Conclusion
The Active Management Value Ratio™ 3.0 (AMVR) is a simple, yet very effective, tool that investment fiduciaries, plan sponsors and plan participants can use to identify cost-inefficient actively managed mutual funds and thus better protect their financial security. All of the information needed to perform the AMVR calculations is freely available online at sites such as morningstar.com, fidelity.com, and marketwatch.com.

For those willing to take the time to do the research and the calculations, the rewards can be significant. For fiduciaries, the time spent can be especially helpful in avoiding unwanted personal liability, as plaintiff’s securities and ERISA attorneys are becoming increasingly aware of the forensic value AMVR analysis provides in quantifying fiduciary prudence and investment losses. As a result, more securities and ERISA attorneys are incorporating AMVR analysis into their practices.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, BICE, closet index funds, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, elderly investment fraud, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , | 2 Comments

2017 Year-End Top 10 DC Funds AMVR Analysis

Posted on January 5, 2018 by jwatkins

Each year “Pensions and Investments” publishes a list of the top 50 mutual funds used by defined contribution (DC) plans. The rankings are based solely on the amount of money invested in each fund within DC plans.

I do an analysis of the top 10 tens non-index funds using my proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR) The AMVR is based on the studies of Charles Ellis and Burton Malkiel. The AMVR measures the cost-efficiency of a fund, as cost consciousness is a fiduciary duty under Sections 88 and 90 the Restatement (Third) Trusts. Funds that do not provide a positive incremental return for investor, or whose incremental costs exceed their positive incremental returns, are deemed to be cost inefficient since the investor would suffer a net loss under either scenario.

This years top 10 non-index based funds used by DC plans are:

Fidelity Conta K(FCNKX) – LCG
American Funds Growth Fund of America R-6 (RGAGX) – LCG
American Funds Fundamental Investor R-6 (RFNGX) – LCB
American Funds Washington Mutual R-6 (RWMGX) – LCV
Dodge & Cox Stock (DODGX) -LCV
Vanguard PRIMECAP Admiral (VPMAX) -LCG
Fidelity Growth Company K (FGCKX) -LCG
T. Rowe Price Blue Chip Growth (RRBGX) – LCG
MFS Value R-6 (MEIKX) -LCV
Fidelity Low Price Stock K (FLPKX) – MCV

Each of the funds was analyzed using Ellis’ incremental cost/return analysis approach, using the following Vanguard funds as their benchmarks:

Vanguard 500 S&P 500 Index Fund Admiral (VFIAX) – Large Cap Blend
Vanguard Growth Index Fund Admiral (VIGAX) – Large Cap Growth
Vanguard Value Index Fund Admiral (VVIAX) – Large Cap Value
Vanguard Midcap Value Index Fund Admiral (VMVAX) – Midcap Value

A fund’s incremental cost number is based on a combination of a fund’s annual expense ratio and its trading costs. Since funds are not required to disclose its actual trading costs, such costs are estimated using John Bogle’s trading costs metric.

A fund’s incremental return number is based on a fund’s risk-adjusted return. Many investment industry professional ignore risk related returns, with the oft heard criticism that “investors can’t eat risk-adjusted returns.” However. interestingly enough, many actively managed funds actually post lower standard deviations, and thus improve their return numbers when a risk-adjusted calculation is performed. Secondly, many actively managed funds have no problem touting their Morningstar “star” rating in marketing their funds. Morningstar is on record as stating that their star ratings are based on risk-adjusted returns.

That said, four of the ten funds failed to provide a positive incremental returns over the past five-year period, January 1, 2013 to December 31, 2017:

American Funds Fundamental Investors
Dodge & Cox Stock
T. Rowe Price Blue Chip Growth
Fidelity Low Price Stock

One fund, Fidelity Growth Company, did produce a positive incremental return. However, the fund’s incremental costs exceeded its incremental return, so the fund is deemed cost inefficient since an investor would suffer a net loss.

The remaining five funds produced positive incremental returns that exceeded their incremental costs, thus qualifying them for an AMVR score. Since AMVR measure incremental costs relative to incremental returns, the lower the AMVR score the better. The five funds and their AMVR scores were:

Vanguard PRIMECAP Admiral – .07
American Funds Growth Fund of America R-6 – .58
Fidelity Conta – .59
American Funds Washington Mutual – .76
MFS Value – .87

The optimal AMVR score would be greater than zero, but less than 1.oo since 1.00 would indicate that the fund’s incremental costs equal its incremental return.

The final fiduciary prudence consideration is the “closet index” fund screen. A familiar fiduciary axiom is that it is never prudent to waste a client’s money. Likewise, by its very nature, a closet index fund is never cost efficient or prudent. All ten funds had a correlation of 90 or above relative to their Vanguard benchmark fund. The correlations were as follows:

Fidelity Conta – 96
American Funds Growth Fund of America – 97
American Funds Fundamental Investor – 98
American Funds Washington Mutual  – 96
Dodge & Cox Stock – 90
Vanguard PRIMECAP Admiral – 95
Fidelity Growth Company – 94
T. Rowe Price Blue Chip Growth- 97
MFS Value – 98
Fidelity Low Price Stock – 93

While there is no universally agreed correlation number that classifies a mutual funds as a closet index fund, most experts agree that a correlation of 90 or above can be considered an indication of closet index status.

Conclusion
Just as the plaintiff’s bar has become more of the Restatement (Third) Trust’s position regarding a fiduciary’s duty to be cost conscious, so too must plan sponsors and other ERISA fiduciaries recognize such fiduciary duty and evaluate their plan’s investment option to maximize the effectiveness of their plan and reduce the potential for liability exposure. both for the plan and themselves.

As this study shows, it is possible for actively managed funds to achieve an acceptable AMVR score, thereby indicating that a fund is cost efficient in terms of incremental costs and incremental. returns. However, even when a favorable AMVR score is obtained, plan sponsors and other investment fiduciaries still need to address the closet index issue by comparing the costs of an actively managed fund, including the fund’s trading costs, to an appropriate benchmark to ensure that they avoid the closet index “trap.”

 

 

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, BICE, closet index funds, compliance, cost consciousness, DOL fiduciary rule, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, pension plans, prudence, retirement plans, wealth management | Tagged , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Fiduciary Litigation 2018: A Pure Heart and an Empty Head Are No Defense

Posted on December 31, 2017 by jwatkins

After my recent post, “Are We At A ‘Tipping Point’ in ERISA Fiduciary Litigation,” I received a number of calls and emails from legal colleagues and investment professionals who wanted to discuss the points I raised.  In the post, I suggested that in my opinion, we are at a tipping point due to several key facts.

First, as a result of SCOTUS’ decision in Tibble v. Edison Int’l, we now know that we can look to the Restatement (Third) Trusts (Restatement) for guidance and the applicable standards in fiduciary law, including ERISA related fiduciary matters.

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 duties, courts often must look to the law of trusts.

Second, my LinkedIn colleague, Gina Migliore, recently posted an article,”Hey Plan Sponsor, In Case You Did Not Know, You’re a Fiduciary,” addressing the fact that far too many plan sponsors still do not realize their fiduciary status or understand the legal obligations and liability exposure resulting from this designation.

These two facts lead me to believe that 2018 will not only see an increase in fiduciary related litigation, both ERISA and non-ERISA cases, but an increased in the success of such litigation. Plans and plan sponsors have celebrated recent wins in a few ERISA fee-based cases. However, I contend that those decisions are tenuous at best, at least with regard to the technical ERISA issues, due to what appears to be incorrect interpretations of cases such as Tibble and Hecker I and Hecker II. As a result, I would expect those key ERISA related decisions to be reversed, a sentiment recently expressed by leading ERISA plaintiff’s attorney, Jerome Schlichter.

In my opinion, the primary reason that ERISA fee actions are so successful is a misunderstanding among plan sponsors, plan advisers and financial advisers in general with regard to the evaluation and ongoing monitoring of investment fees. Whenever the issues of fees is raised in ERISA cases, plan sponsors and the investment immediately respond that ERISA does not require that they select the investment options with the lowest fees.

While this is true, is does not equate with an absolute immunity from recommending and selecting investment options that lack any inherent value for investors and pension plan participants. Taking Justice Breyer’s statement with regard to the value of the Restatement in interpreting fiduciary law as a starting point allows us to evaluate the viability of investment options using the clear and simple standards set out in the Restatement. Three standards in particular stand out, two setting out core fiduciary standard, and one setting out the fiduciary standard for actively managed mutual funds, a staple in most 401(k) plans and other types of pension plans.

With regard to a fiduciary’s core duties, Section 88 states that fiduciaries have a duty to be cost conscious. Section 90, comment f, states that fiduciaries have a duty to seek the highest return for a given level of risk and cost, or conversely, the lowest level of cost and risk for a given level of return. With regard to actively managed mutual funds, Section 90, comment h(2), of the Restatement notes that such investments often carry a higher level of costs and risks than comparable index funds. Therefore, the Restatement states that actively managed funds should only be included in a plan’s investment options when the expected return from such fund can reasonably be expected to provide a commensurate level of return o compensate for the additional costs and risk of the actively managed funds.

Simply put, the current menu of investment options within most 401(k) and other pension fail to meet any of these three hurdles. Not only fail to meet them, but fail miserably to meet such standards. As Carhart’s study showed, the returns of most actively managed funds fail to even cover their costs.(1) Our proprietary metric, the Active Management Value Ratio 2.0™ (AMVR), also shows that most actively managed mutual funds are not cost efficient, as their incremental costs exceed their incremental returns, as compared to an appropriate benchmark. As has been mentioned in several ERISA fees cases, losing a client’s money is never prudent.

The fact that many plan sponsors still do not recognize their fiduciary status and resulting fiduciary duties means that they are probably not aware of the standards established by the Restatement and the resulting liability exposure for failure to adhere to same. Ergo, increased litigation and more settlements and decisions in favor of plan participants.

The first time I meet with a prospective ERISA client, I ask them to tell me everything they know about ERISA law. The usual response is either along the lines of knowing that they have to comply with the rules to an immediate “deer in the headlights” stare. They often provide audit notes from a compliance advisor that list the usual 20-25 compliance requirement under the ’40 Act.

More often than not, the compliance adviser is not attorney and does not recognize the need to integrate both compliance and legal risk management standards into a plan to provide the plan with optimum legal protection. Far too often I see plans that offer 40-50 investment options, obviously operating under the mistaken belief that more is better, when in fact just the opposite is usually true. Offering a lot of funds that are highly correlated to each other and/or are cost inefficient, e.g., closet index funds, offers nothing for either the plan or the plan participants except liability exposure for the plan and the plan sponsor.

These very issues were discussed and resolved  in the Hecker decisions. In my experience, far too many compliance consultants and plan providers rely on Hecker I without reviewing Hecker II. As Fred Reish, one of America’s leading ERISA experts, admits, Hecker II effectively reversed Hecker I. As a result, many plan sponsors are left, as we say in the South, “nekkid in the wind,” totally defenseless to any ERISA fee litigation action.

CEOs and 401(k) plan sponsors often call me asking me how they can bulletproof their plan and avoid any liability. First the bad news. Since 401(k) fee cases address thing s that have occurred within the past six years, there is nothing a plan can do about liability arising from actions during that time. You can’t unring a rung bell.

The good news is that plans can implement and monitor an effective risk management program that provides the protection and benefits that both plan sponsors and plan participants want and need. Such risk management programs do not have to be cost prohibitive either. The key is to become and remain proactive in creating such as plan and monitoring the plan to ensure continued effectiveness.

One last factor to consider is the continuing efforts of the DOL, Congress and the Trump administration to block the full implementation of the DOL’s new fiduciary standard. In so doing, the DOL and Congress, as well as the SEC, underestimated the response from the states. Some states already impose a fiduciary duty on stockbrokers and other financial advisers. Nevada and other states have announced plans to protect their own citizens by exercising their police powers under the 10th Amendment to enact their own fiduciary standards. These state fiduciary laws will presumably include full discovery rights for investors, the one thing that the investment industry fears the most due to the possibility that it will expose even greater abuses by the industry. And there is nothing that Congress, the DOL, the SEC or the Trump administration can do to prevent the states from exercising their 10th Amendment rights and powers.

Increased fiduciary related litigation and more settlements and plaintiffs’ verdicts.  That’s my prediction and I’m sticking to it!

Selah

Notes
1. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.

Copyright © 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 401k, 401k compliance, 403b, 404c, closet index funds, cost consciousness, DOL fiduciary rule, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans | Tagged , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

There Are No Mulligans in Fiduciary Law

Posted on November 25, 2017 by jwatkins

Webster’s dictionary defines a mulligan as “a free shot sometimes given a golfer in informal play when the previous shot was poorly played.” While various organizations are currently promoting various erroneous definitions of “fiduciary” and what a fiduciary’s duties include, as the Supreme Court noted in Tibble v. Edison International,(1) the courts usually look to the Restatement (Third) Trusts for guidance on fiduciary questions, especially in cases involving ERISA.

The issue of erroneous fiduciary definitions recently was spotlighted when Secretary of Labor Acosta testified before a Senate committee. In responding to a question posed by Congressman Robert Scott, D-Va., with regard to the department’s enforcement of their new fiduciary rules, Acosta responded by saying that

If companies are not proceeding in good faith [with the best interest standard], we still have enforcement authority. So if there are willful violations, we do have enforcement authority.

Huh? “Good faith” and “willful violations” as defenses, or perhaps more accurately loopholes, to breaches of one’s fiduciary duties. Mr. Secretary, as an attorney, you know, or should know, that the courts have consistently held that “a pure heart and an empty head” are no defense to allegations involving the breach of one’s fiduciary duties.(2) Any violation of one’s fiduciary duties, whether willful or not, are actionable, as a fiduciary ‘s duties are the highest known at law. A fiduciary liability for any mistakes is essentially absolute…no mulligans!

The courts and the regulators, as well as the Restatement, have consistently held that good faith alone is not a defense a breach of one’s fiduciary duties. Some examples include:

When a trustee “violates a duty because of a mistake as to the extent of his duties…he is not protected because he acts in good faith nor is he protected merely because he relies upon the advice of counsel.”(3)

ERISA’s reference to good faith is limited by the “overriding duties imposed by [ERISA Section] 404.(4)

“[A] fiduciary’s subjective good faith belief of his prudence will not insulate him from liability”(5)

“ERISA does not excuse a fiduciary’s breach of duty because the fiduciary acted in good faith.”(6)

“The fiduciary’s subjective good faith belief in an investment does not insulate him from charges that he acted imprudently.”(7)

A Test For Acosta and the DOL Truth-O-Meter
If we take Secretary Acosta at his word regarding pursuing enforcement for willful violations by companies not acting in good faith, then it will be interesting to see how, or if, the department will pursue the sale of variable annuities in connection with pension plans and plan participants. Variable annuities are annually among the top investments involved in customer complaints. Statistics show that the highest percentage of variable annuities sales are within pension plans and to plan participants.

There is a saying in the investment industry – annuities are sold, not bought. When one understands the high fees and associated costs associated with most annuities, especially variable annuities, and the impact of such fees and costs, the truth of the saying is clearly obvious. Since the cumulative fees and costs associated with variable annuities typically run in the 2-3 percent range, and each additional 1 percent in costs reduces an investor’s end return by approximately 17 percent over twenty years, a variable annuity investor could easily see over of their returns going to the variable annuity issuer in the form of fees and costs. So much for “retirement readiness” and “financial wellness.”

Moshe Milevsky’s study(8) of variable fees concluded that the fees charged by the average variable annuity, even in the best case scenarios, were 5-10 higher than the actual economic value of the benefit conveyed, thereby providing a windfall for the variable annuity issuer at the variable annuity owner’s expense. Fiduciary law is based primarily on the common law of equity. A basic axiom of equity law is that equity abhors a windfall. Therefore, the fact that most variable annuities produce a windfall for the issuer effectively negates any argument that recommendations of variable annuities to pension plans and plan participants cannot be said to be made in “good faith” and are therefore “willful” violations of one’s fiduciary duties. So, will we see enforcement actions initiated by Secretary Acosta and the department, or was this empty rhetoric by Secretary Acosta to placate Congress?

Simple, easily verifiable facts, especially by attorneys such as Secretary Acosta and the excellent attorneys there at the Department of Labor. Throw in the added fact that Secretary Acosta’s newly created loopholes, “good faith” and “willful” are inconsistent with long-standing fiduciary law, and the burden on Secretary Acosta and the department is to do their job and truly enforce the new fiduciary rule in order to carry out the department’s mission statement – to protect American workers and pension plan participants.

Notes
1. Tibble v. Edison International, 135 S. Ct. 1823, 1828 (2015)
2. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983)
3. Restatement (Second) of Trusts §201 cmt. a (1959)
4. Cunningham, 1467
5. Reich v. King, 867 F. Supp. 341, 343 (D. Md. 1994)
6. Martin v. Walton, 773 F. Supp. 1524 (S.D. Fla.1991)
7. Lanka v. O’Higgins, 810 F. Supp. 379, 387 (N.D.N.Y. 1992)
8. Moshe Milevsky, “Confessions of a VA Critic,” Research Magazine, January 2007, 42-48

© Copyright 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

 

Posted in Annuities, BICE, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, pension plans, retirement plans | Tagged , , , , , , , , , | Leave a comment

Are We At a “Tipping Point” in ERISA Fiduciary Litigation?

Posted on November 16, 2017 by jwatkins

As I went through my daily social media review, I noticed a post indicating that DOL Secretary Acosta has indicated that the DOL is ready to enforce the department’s new fiduciary rule (“Rule”). Excuse me if I’m skeptical, given the Secretary’s seeming opposition to the rule before he was even confirmed as Secretary.

Or perhaps Nevada’s announced intention to adopt its own state fiduciary law, as well as other states’ interest in doing the same, has caused Acosta to make his announcement, since state laws would ensure access to the courts for pension plan participants, making the Rule and accompanying best interests contract exemption, known as BICE, potentially irrelevant.

The Rule and BICE have the potential to address the ongoing abusive practices that drove the adoption of the Rule in the first place. However, the ongoing efforts of the DOL and Congress have raised serious questions as to whether the Rule and BICE will ever be totally effective. Hopefully, the states will follow through and adopt state fiduciary laws to ensure that investors, both retail and pension plan participants, are properly protected against the abusive marketing practices by the investment industry.

A number of recent decisions dismissing 401(k) actions involving fees and breach of fiduciary duties has caused some commentators and investment industry leaders to claim that the tide has shifted and such actions will meet with similar summary dismissals going forward. However, a closer analysis of the decisions suggests that such dismissals may result in nothing more than a false sense of optimism.

In reviewing the recent dismissals, the court’s rationale in dismissing the action typically involve three themes: the number of funds offered by a plan; the fact that a plan’s fees have been “approved” in other 401(k) actions, and/or alleged deficiencies in the plaintiff plan participants’ pleadings. With all due respect, the courts’ use of such issues appear to be inconsistent with prior court decisions and the primary resource used by the courts in fiduciary cases, especially actions involving ERISA issues. Pleading issues can always be addressed and prevented.

Dismissals Based on Number of Investment Options
Courts dismissing 401(k) actions involving fee and/or fiduciary breach issues based upon a plan’s number of investment options have frequently cited the decision in Hecker v. Deere(1) as justification for their decision. In that decision, the court appeared to suggest that the mere number of funds offered by a plan could ensure that the plan was insulated from liability for alleged breach of fiduciary duties.

However, the courts seemingly have ignored the fact that the 7th Circuit Court of Appeals subsequently went back and “clarified” their early decision in what is often referred to as Hecker v. Deere II(2). Most legal experts agree that the court’s “clarification” was actually a reversal of their earlier decision. Responding to concerns from the DOL and others that the court’s first decision was contrary to law and denied plan participants with basic  protections guaranteed under ERISA, the 7th Circuit sated that their earlier decision did not, and was not intended to, insulate plan sponsors and other plan fiduciaries, saying

The Secretary also fears that our opinion could be read as a sweeping statement that any Plan fiduciary can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such ‘‘obvious, even reckless, imprudence in the selection of investments’’ (as the Secretary puts it in her brief).(3)

So any decision dismissing a 401(k) fees/breach of fiduciary duties based on the number of investment option within a plan, with no consideration of the prudence of same, would be improper.

Dismissals Based on Investment Fees Being Within an Allowable Range
There is nothing in ERISA mentioned any specific allowable range of fees. The whole “allowable range” of fees theory has been derived by the courts and the investment industry based on cases in which ranges of fees were deemed fair and appropriate.

An interesting aspect of this logic is that for years the investment industry consistently argued that evaluating actively managed funds based purely on fees rather than the value provided by such funds was unfair and inappropriate…and they were, and still are, absolutely correct. And yet, that appears to be exactly what the courts are now doing.

As the Supreme Court has noted,

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

The Restatement of Trusts sets out the common law of trusts. The Restatement’s position is that fees for actively managed mutual funds should be evaluated relative to the incremental return that such incremental fees and costs provide. Noting the extra costs and risks typically associated with actively managed funds relative to comparable index funds, the Restatement states that

those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…(5)

This is a significant hurdle for any plan choosing to offer actively managed funds. Analyses such as Standard & Poor’s Indices Versus Active Management (SPIVA) consistently show that most actively managed funds fail to outperformed their relative indices. Academic studies by well-respected parties such as Carhart(6) and Edelson, Evans and Kadlec(7)  go even further, as their findings show that most actively managed funds do not even manage to cover their costs, resulting in a net loss for investors.

The courts’ reliance on the “allowable range” logic is clearly inappropriate and indefensible as it ignores the importance of the requisite inherent value of a fund in terms of the positive incremental return, if any, provided to an investor. A basic axiom of fiduciary law is that “wasting beneficiaries’ money is imprudent.”(8) Before dismissing a 401(k) fees/fiduciary breach action, courts should compare an actively managed fund’s incremental return to the fund’s incremental costs.

Dismissals Based on Pleading Insufficiencies
Many of the recent dismissals involving   401(k) fees/fiduciary breach actions cited pleading insufficiencies such as failure to properly plead wrongful conduct and/or damages. The courts have every right to demand proper pleading from plaintiffs’ attorneys. Fortunately, such errors are easily corrected. Properly pleaded complaints should survive any motion to dismiss filed by the defendants.

Going Forward-Are We At a “Tipping Point” in ERISA Fiduciary Litigation?
In my humble opinion, the answer is “yes.” The rationale behind m opinion is that the courts will have little “wiggle room” to dismiss a 401(k) fees/fiduciary breach action if the action is properly plead and proper negation of the number of funds or “allowable range” of fees arguments in connection with any motion to dismiss.

Given the legal system’s reliance on the Restatement of Trust, investment fiduciaries, including plan sponsors, should know and understand the Restatement’s position on various fiduciary issues, especially Section 90 of the Restatement, more commonly known as “The Prudent Investor Rule.”

I continue to be amazed at how many investment fiduciaries have never looked at the Restatement. The usual response is that they will simply plead lack of knowledge and innocent mistake. For fiduciaries adopting such a strategy, expect to hear one or both of the following fundamental legal axioms – “ignorance of the law is no excuse” and “ a pure heart and an empty head are no defense in actions involving alleged breaches of one’s fiduciary duties.”

I expect to see more 401(k) fees/fiduciary breach actions focusing on the forgotten fiduciary duty, a fiduciary’s duty to be cost-conscious.(8) Restatement Section 88. Based on the SPIVA reports and my years of forensic analyses of actively managed mutual funds, very few actively managed mutual funds meet the Restatement’s requirement of cost-efficiency.

Using resources such as the Restatement and previously mentioned SPIVA reports, the academic studies of Carhart and Edelson, and InvestSense’s metric, the Active Management Value Ratio (AMVR™), plaintiff’s attorneys can easily establish the cost-efficiency of a plan, essentially bulletproofing their cases against successful dismissal actions. Elimination or a significant reduction in dismissal of 401(k) fees/fiduciary breach cases would clearly result in a “tipping point,” as pensions plans and investment fiduciaries would be forced to adopt prudent processes to ensure that they meet the applicable fiduciary standards or face the consequences.

Notes
1. Hecker v. Deere (Hecker I), 556 F.3d 575 (7th Cir. 2009)
2. Hecker v. Deere (Hecker II), 569 F.3d 708 (7th Cir. 2009)
3. Hecker II, at 711
4. Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015)
5. Restatement (Third) Trusts, Section 90 cmt h(2)
6. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
7. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/abstract=951367
8. Uniform Prudent Investor Act (UPIA), Section 7, comment

Copyright © 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , | Leave a comment

Unintended Consequences: Financial Advisers and Potential Liability Issues Under State Fiduciary Laws

Posted on October 29, 2017 by jwatkins

With the investment industry driving and celebrating the continuous efforts of the DOL and Congress to emasculate the DOL’s fiduciary rule, I have received emails from stockbrokers and RIAs/IARs as to what the practical meaning of these actions, from a both a practice management and potential liability standpoint. I do believe that the actions of Congress and the DOL have important implications for the investment industry, including ERISA activity. I also believe that the industry may not be celebrating quite as loudly if some scenarios come true.

In my opinion, the development that could have the most impact on the investment industry is Nevada’s announcement that it will enact a state fiduciary law pursuant to its police powers under the 10th Amendment. A number of states already hold stockbrokers to a fiduciary standard as a result of state laws and/or state court decisions. RIAs and IARs are already held to a fiduciary standard under federal and state law.

Nevada’s announcement, and their announcement that other states had contacted them about following Nevada’s lead, caused quite a reaction in the investment world. Industry trade groups objected to such a move, claiming that ERISA was exclusively a federal issue and that Nevada’s passage of such a law would cause confusions. That argument has no merit, for as mentioned earlier, numerous states already hold stockbrokers and other financial advisers to a fiduciary standard. Furthermore, as long states approach any stockbroker and financial activity in the proper manner, there is nothing that the DOL, Congress, the administration or the courts can do to prevent any state from passing such state fiduciary laws, as it is within their 10th Amendment powers.

I have long been of the opinion that the real reason that the investment industry and other industry groups are so fervently concerned about the DOL rule is that it would protect an investor’s right to pursue legal recourse for violations in the courts, which in turn would provide investors with the right to full discovery. While an investor has a very limited right to discovery in arbitration, investors would enjoy a much broader right of discovery in the courts, discovery which result in the uncovering of other abusive practices by members of the investment industry and stronger cases by investors.

The current state fiduciary laws apply to any and all activity engaged in by stockbrokers and other financial advisers. As a result, current state fiduciary laws, as well as similar laws enacted by Nevada and other states going forward, could effectively replace a watered down or completely repealed BIC exemption since BICE, as currently proposed, applies to what is otherwise a simple securities situation, not an ERISA plan situation.

Waiver of Access to the Courts and Class Action Participation
As a plaintiff’s attorney myself, I have had already had several discussion with other plaintiff’s attorneys on potential issues resulting from the actions of the DOL and Congress, particularly the attack on the prohibition of forced binding arbitration provisions in BIC exemption agreements. The key issue in this regard would be whether any financial adviser who is subject to a fiduciary standard would violate their fiduciary duty of loyalty by advising, or forcing, an investor to forego an important and valuable legal right by waiving their right to pursue legal resource in the courts.

The securities arbitration process has long been the subject of criticism due to perceived manipulation of the process by the regulators and the investment industry. While things have improved somewhat, there is still the perception that investors would have a better opportunity for a fair and impartial trial in the courts. There is also the issue that recent evidence has shown that many stockbrokers and advisers who lose in arbitration never pay the winning investors the amounts awarded to them, with the regulators never doing anything to require such payments. Investors in court cases would have a number of legal options available to collect such financial awards.

The waiver of an investor’s right to redress in the courts would also have potential ERISA implications for plan sponsors, as they could be held liable for breach of their duty of loyalty by selecting a plan provider that required such a waiver, when other options were available that would not have required such waivers. As discussed earlier, such waivers are clearly not in the best interest of plan participants and investors.

Going Forward
Once I explain the practical implications of the situation, the next question inevitably involves some variation of “so what do I do?” My response is to continue to do what you have hopefully been doing all along. As mentioned earlier, RIAs and their representatives are already held to the “best interests” requirement of the fiduciary standard.

Broker-dealers and stockbrokers are always quick to claim that they are subject to the less stringent suitability standard, which does not require them to act in the best interests of a customer. I would suggest that recent regulatory releases and previous regulatory enforcement decisions suggest otherwise.

In interpreting FINRA’s suitability rule, numerous cases explicitly state that “a broker’s recommendations must be consistent with his customers’ best interests.” The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests…. The requirement that a broker’s recommendation must be consistent with the customer’s best interests does not obligate a broker to recommend the “least expensive” security or investment strategy (however “least expensive” may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer’s interests…. the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined. – FINRA Regulatory Notice 12-25 (emphasis added)

In interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s ‘best interests.’ – Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009)

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests. – Wendell D.Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154, at *11 (2003)

[A] broker’s recommendations must serve his client’s best interests. – Dep’t ofEnforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC Aug. 9, 2004)

In resolving the best interests question, I have always advised my consulting clients to follow the guidelines set out in the Restatement (Third) Trusts’ Prudent Investor Rule, especially the Restatement’s “forgotten” fiduciary duty, the duty of being cost conscious, as set out in Section 88 and Section 90, comment b. Stockbrokers and other financial advisers who recommend actively managed mutual funds to clients show pay particular attention to the fiduciary prudence standard set out in Section 90, comment h(2), which states that due to the additional costs and risks associated with actively managed funds as compared to index funds, actively managed funds should only be recommended if it is reasonable to assume that the gains from such actively managed funds will  compensate an investor for such additional costs and risks.

This is a significant hurdle for most actively managed funds, as studies such as Standard & Poor’s SPIVA reports and academic studies such as those done by Carhart(1) , Edelen, and Kadlec (2) have consistently found that most actively managed funds not only do not outperform comparable index funds, but that many actively managed mutual funds do not even manage to cover the fund’s costs. Underperforming funds and those that actually cost investors due to excessive costs clearly do not satisfy the “best interests” standard of either the common law fiduciary standard or FINRA’s suitability/best interest standard.

For stockbrokers and others who still do not believe they need to comply with a “best interests” standard in making recommendations, I would point to various courts’ rulings where they have agreed to impose a fiduciary duty on brokers advising accounts, even non-discretionary accounts, when justice and sense of fundamental fairness dictate same, with the admonition that

The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.  Follansbee v. Davis, Skaggs & Co., Inc., 681F.2d 673, 677 (9th Cir. 1982)

The issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s recommendations. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir 1975)

Conclusion
Gordon Gecko’s “greed is good” speech notwithstanding, the investment industry’s greed in trying to emasculate or completely repeal the DOL’s fiduciary rule has apparently resulted in a number of states proposing to join existing states with fiduciary laws in order to protect their citizens. Such fiduciary laws will govern all of a financial advisers actiities, not just ERISA related activity. Since no one can prevent the states from enacting  such legislation, prudent stockbroker and financial advisers will review the common law prudent/best interest investment standards as set out in the Restatement (Third) Trusts and adjust their business and due processes accordingly to avoid unnecessary liability exposure, whether in arbitration or in the courts.

Notes
1. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
2. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/ abstract=951367

© Copyright 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in BICE, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, pension plans, prudence, retirement plans, RIA, RIA Compliance | Tagged , , , , , , , , , , , , , , , , | Leave a comment

Don’t Poke the Bear: Nevada Rains on Anti-Fiduciary Rule Parade

Posted on October 10, 2017 by jwatkins

It is well established that ERISA comprehensively regulates employee pension and welfare plans, and t hat in the area of its coverage it preempts state laws and regulations. …However, it is also clear that there is a presumption against preemption, and that while ERISA’s preemptive effect is broad, it is not all-encompassing. As the Supreme Court has stated,”[s]ome state actions may affect employee benefit plans in too tenuous, remote, or peripheral a manner to warrant a finding that the law ‘relate to the plan….”
Duffy v. Cavalier, 215 Cal.App.3d 1517, 1527 (1989)

Most people are familiar with Gordon Gekko’s famous line from the movie “Wall Street”-“greed is good.” Right now, I’m guessing that the Department of Labor, Secretary Acosta, the investment industry and its trade groups are seriously questioning the accuracy of that statement.

Ever since Secretary Acosta assumed his position, he has made no secret of his pro-investment industry, anti-DOL’s new fiduciary rule position. The investment industry has made various requests in an effort to kill or seriously limit the impact of the rule. In each case, Acosta has granted their wishes, even thought the DOL was crested to protect the interests of American workers, not the investment industry. Secretary Acosta, the DOL, the investment industry and its trade groups have essentially thumbed their noses at American plan participants and retirees with indignation, sending the clear message that the DOL does not care about them.

However, there is another familiar saying–“be careful what you wish for.” In this case, you can only bully people for so long before they decide to fight back. The bullying efforts of the DOL and investment industry have now been countered by the state of Nevada’s announcement that the intend to exercise their 10th Amendment  police powers to protect their citizens by holding all stockbrokers and financial adviser in their state to a fiduciary standard.

Pandora’s box is officially open and the investment industry has clearly indicated its concern, and rightfully so. Other states have used legislation and/or court decisions to hold stockbrokers and financial advisers to a fiduciary standard for some time. Nevada’s announcement, and their statement that other states have already contacted them about following their lead, has implications far beyond just ERISA. States adopting a fiduciary standard for stockbrokers and financial advisers apply the standard to all activities of these parties, not just ERISA related activities. Greed is not good.

The investment industry’s response to Nevada’s annoouncement thus far has been a feeble allegation that Nevada’s adoption of a fiduciary standard for stockbrokers and financial advises will create confusion. What the investment industry and its trade groups realize is that that there is nothing they can do legally to prevent Nevada or any other state from creating and enforcing such laws under their 10th Amendment police powers. Likewise, there is nothing that the Trump administration, the DOL or Secretary Acosta can do to prevent Nevada from enacting such laws.

Equally troubling for the investment industry and other opponents of the DOL’s fiduciary standard is the fact that Nevada’s right to so act and the implications of such actions in ERISA cases has already been addressed in a well-reasoned decision, the aforementioned case of Duffy v. Cavalier. With regard to the DOL’s fiduciary rule. more specifically the DOL’s threats to essentially emasculate the Best Interest Contract exemption (BICE), Duffy stands for the proposition that states can enact laws to allow their citizens to protect their financial interests and preserve their access to the state’s court to do so.

Again, such fiduciary standards would apply to all activities of stockbrokers and financial advisers, not just ERISA related activity. Again, as long as states follow the guidelines set out in Duffy, there is absolutely nothing that the DOL, the investment industry or their trade groups can do to prevent any state from exercising its constitutionally protected 10th Amendment rights in enacting such fiduciary standards.

Nobody likes a bully. As they like to say here in the South, Secretary Acosta, the investment industry and its trade groups got greedy, “got too big for their britches,” and as a result, Nevada and other states decided that if the DOL was not going to do its job and protect plan participants and retirees, then they will use their police powers to do so. As a result, the investment industry has simply ensured that its members will face more stringent regulations and liability exposure in all of its activities, and there is nothing they can do to prevent same.

Check and checkmate.

P.S. For those wanting to read the Duffy decision, the decision can be accessed via www.leagle.com and searching the site using “Duffy v. Cavalier.”

Posted in 401k, 404c, 404c compliance, BICE, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, Fiduciary prudence, fiduciary standard, pension plans, prudence | Tagged , , , , , , , , , , , | Leave a comment

Transparency Is the Best Sunlight: Four Due Diligence Questions Plan Sponsors and Plan Participants Should Ask

Posted on September 22, 2017 by jwatkins

Sunlight is the best disinfectant. – Justice Brandeis

The ongoing attempts by the Department of Labor (DOL) and Congress to delay or completely reverse the DOL’s fiduciary rule sends a clear message to pension plan sponsors and plan participants – we care more about Wall Street and the overall investment industry than we do about you.

The arguments put forth by Wall Street and the investment industry thus far have been nothing more than self-serving rhetoric and speculation, totally devoid of any legally admissible evidence. And yet, both the DOL and Congress have gone out of their way to agree to any requests for further delays in full implementation of the DOL’s new fiduciary rule.

The DOL recently agreed to delay the effectiveness of the full DOL rule for eighteen months, even though a private foundation estimated that the delay would result in an $11 billion loss to pension plan participants. The DOL agreed to the additional delay even though CEOs for some of the nation’s leading broker-dealers have publicly stated that no delay is necessary, that they were completely prepared for a full and immediate implementation of the DOL’s rule.

So what does this all mean for plans, plan sponsors and plan participants, the primary beneficiaries of the DOL’s fiduciary rule? It means that they need to become more proactive in order to protect their financial security or, in the case of plan fiduciaries, to protect against any unwanted potential personal liability.

In my legal and fiduciary consulting practices, I use five core questions to establish the failure of a meaningful due diligence process by a financial adviser and resulting unsuitable/imprudent advice, in both ERISA and non-ERISA situations. The five core questions that I use in my practices analyze the true nature of the effective returns that investors receive once certain factors are considered. The four factors that I consider in my forensics analyses are: nominal, or stated, annualized returns;  load-adjusted annualized returns; risk-adjusted annualized returns, and potential “closet index” returns, using both Ross Miller’s Active Expense Ratio metric and my Active Management Value Ratio™ 3.0 metric.

Nominal, or Stated, Returns
These are essentially a fund’s absolute returns, based on the difference between a fund’s beginning and ending value over a certain period of time, with no consideration of any other factors. A fund that started the year with a balance of $10,000 and a balance of $10,000 at the end of the year would have earned a return of 10 percent for the year. [(11,000-10,000)/10,000=1,000/10,000, or 10 percent.

Load-Adjusted Returns
The problem with using nominal returns in analyzing a fund’s performance is that it overstates a fund’s effective annualized returns if an investor paid a front-end fee, or load, when they purchased the fund. Front-end loads are immediately subtracted from a fund at the time they are purchased, putting an investor who pays a front-end load behind investors who do not pay a front-end load when they purchase their mutual fund shares.

All things being equal, a front-end load will always cause an investor paying same to lag behind an investor who did not pay any type of load. And the difference in cumulative returns grows larger over time. As a result, mutual funds often use various marketing techniques in an attempt to conceal the negative impact of front-end loads on returns.

Mutual funds are required by law to disclose a fund’s load-adjusted return in a fund’s prospectus. However, it is common knowledge that most investors do not read a fund’s prospectus. One common marketing technique that fund companies use in advertising to hide the negative impact of front-end loads on returns is to use a fund’s nominal returns rather than its lower load-adjusted returns in their ads.

Then, in an attempt to avoid any potential charges of violations of the Exchange Act or the Advisors Act, the fund will ad a footnote, in much smaller print, at the end of the article stating that they did not use the fund’s load-adjusted returns and that, had they done so, the fund’s return numbers would have been lower. They never say how much lower or provide the actual load-adjusted returns numbers. In my opinion, the use of such tactics by a fund or financial adviser is a clear indication of their business ethics and respect for investors, or their complete lack thereof.

Risk Adjusted Returns
Studies have suggested a direct relationship between the level of investment risk assumed and investment return. As the Restatement (Third) Trusts (Restatement) points out, the natural inclination of investors and the duty of investment fiduciaries is to seek the highest level of return for a given level of risk and cost.

The investment industry often downplays the evaluation of a fund’s risk-related returns, with the familiar quote, “investors cannot eat risk-related returns.” However, mutual funds certainly have no problem referencing the number of Morningstar “stars” one of their funds earned if the rating is favorable, even though Morningstar has publicly acknowledged that it bases a fund’s “star” rating on the fund’s relative risk-related returns.

“Closet Index” Returns
“Closet index” funds, also known as “index huggers,” have become an increasing issue with regard to wealth management. Closet indexing refers to situations where a mutual fund holds itself out as an actively managed mutual fund, and charging higher fees for such active management, but whose actual performance closely tracks that of a comparable, but less expensive, index fund. Therefore, such funds are not cost-efficient and violate a fiduciary’s duty of prudence.

One of the best ways to identify a closet index is by using a statistic called R-squared (or R2), which measures the percentage of a fund’s movements that can be explained by fluctuations in a benchmark index. The higher a fund’s R-squared number, the greater the likelihood that the funds can be designated as a closet index fund. R-squared  ratings for funds are available for free on various public internet sites, such as Morningstar, Yahoo!Finance and MarketWatch.

One commonly method commonly used to evaluate a fund’s potential closet index status is to use a fund’s R-squared number to compute a fund’s Active Expense Ratio (AER). A fund’s AER number provides investors and investment fiduciaries with a fund’s effective annual expense ratio given the fund’s reduced active management component. In my practice, I take a fund’s AER and use it in my proprietary metric the Active Management Value Ratio™ 3.o (AMVR). The AMVR allows investors and investment fiduciaries to quantify the cost-efficiency of an actively managed mutual fund.

The impact of such returns on the performance of a fund can be seen in the following example. Capital Group’s American Funds mutual funds are among the most commonly recommended funds to both ERISA and non-ERISA accounts. Financial advisors like the fact that American Funds pay one of the highest commission rates of any fund group, based largely on the 5.75 percent front-end load that American charges non-ERISA accounts. ERISA accounts typically do not charge investors a front-end load on their purchases.

In our example, we will compare the ten-performance of two of American Fund’s most popular funds, Growth Fund of America (retail AGTHX, retirement RGAGX) and Washington Mutual (retail AWSHX, retirement RWMGX) to their comparable fund at Vanguard. Morningstar classifies AGTHX/RGAGX as a large cap growth fund and AWSHX/RWMGX as a large cap value fund. We will use the Vanguard Growth Index Fund and the Vanguard Value Index Fund as benchmarks to evaluate the AGTHX/RGAGX and AWSHX/ RWMGX, respectively. Unless otherwise indicated, the return numbers reflect the ten-year period ending June 30, 2017

AGTHX VIGRX
Nominal 7.24 8.65
Load-Adj 6.93 8.65
Risk-Adj 7.05 8.65
AER 4.19 –

*AGTHX 10-year cumulative returns – $197,636
*VIGRX 10-year cumulative returns – $229,243

Here, AGTHX lags VIGRX both in terms of nominal and load-adjusted return. AGTHX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.19, versus its stated annual expense ratio of 0.66 percent, as compared to VIGRX’s annual expense ratio of 0.18. Based on these numbers, it would be hard to justify AGTHX as a suitable/ prudent investment choice over VIGRX.

A similar comparison on the retirement shares of both funds produces the following results.

RGAGX VIGAX
Nominal 7.54 8.80
Load-Adj 7.54 8.80
Risk-Adj 7.67 8.80
AER 4.07 –

*RGAGX 10-year cumulative returns – $209,385
*VIGAX 10-year cumulative returns – $232,428

Once again, RGAGX lags VIGAX both in terms of nominal and load-adjusted return. RGAGX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.07, versus its stated annual expense ratio of 0.33 percent, as compared to VIGAX’s annual expense ratio of 0.06. Based on these numbers, it would hard to justify RGAGX as a suitable/ prudent investment choice over VIGAX.

It should be noted that when using the AMVR, a fund that fails to provide any incremental return for an investor, or a fund whose incremental costs exceed a fund’s incremental return, is clearly unsuitable and imprudent since an investment in the fund would provide no positive benefit for an investor.

Turning to AWHSX and VIVAX, we find the following results.

 

AWSHX VIVAX
Nominal 6.42 5.69
Load-Adj 5.79 5.69
Risk-Adj 6.48 5.69
AER 4.24 –

*AWSHX 10-year cumulative returns – $187,361
*VIVAX 10- years cumulative returns – $173,915

Here, AWSHX has a better performance than VIVAX both in terms of nominal and load-adjusted return. AWSHX has a high R-squared number, 97, which results in a significantly higher effective annual expense ratio of 4.24, versus its stated annual expense ratio of 0.58 percent, as compared to VIVAX’s annual expense ratio of 0.18. Even with AWSHX’s higher incremental return (0.79), the incremental costs (4.06), based on AWSHX’s AER number, greatly exceeds AWSHX’s incremental return. Based on these numbers, it would hard to justify AWSHX as a suitable/ prudent investment choice over VIVAX.

Finally, a comparison of the retirement shares for each fund produces the following results.

RWMGX VVIAX
Nominal 6.68 5.83
Load-Adj 6.68 5.83
Risk-Adj 7.46 5.83
AER 1.76 –

*RWMGX 10-year cumulative returns – $205,337
*VVIAX 10-year cumulative returns – $176,233

RWMGX clearly has significantly higher returns than VVIAX. WMGX has a high R-squared number, 97, which results in a higher effective annual expense ratio of 1.76, versus its stated annual expense ratio of 0.30 percent, as compared to VVIAX’s annual expense ratio of 0.06. RWMGX’s higher incremental return (1.63) exceeds its  incremental costs (1.48). Based on these numbers, RWMGX could be considered a suitable and prudent investment choice for the period analyzed.

Conclusion
Based upon my experience, far too many investors and investment fiduciaries simply take a quick glance at a fund’s nominal return numbers and a fund’s standard deviation and make their decisions based on those numbers alone. Those numbers, alone, simply do not constitute an acceptable due diligence process or a meaningful analysis of a mutual fund.

Based upon my experience, four definite patterns emerge in analyzing mutual funds:

(1) All things being equal, no-load funds typically outperform funds that charge a front-end load and/or excessively high annual expense ratios, especially over the long-term. A front-end load simply puts an investor in a position that is difficult to overcome over the long-term.

(2) Actively managed mutual funds often have lower standard deviation numbers that index funds, showing one potential benefit of active management. However, the difference in standard deviation numbers is rarely enough to make up for the impact of a front-end load.

(3) Both fiduciary and non-fiduciary investors should look for cost efficient funds, funds whose incremental returns exceed a fund’s incremental costs, in order to maximize the benefit of compound returns. Losses, whether due to poor returns and/or excessive costs, deny an investor the benefits of compounds returns.

(4) Closet index funds are never cost-efficient, and therefore are never suitable or prudent investments. Funds with a high R-squared number and/or high incremental cost relative to a comparable index fund should always be avoided, as they are typically the prime candidates for closet index status.

It really is that simple. Investors and fiduciaries should always ask their financial advisors the four questions discussed herein. If an advisor cannot or will not supply all such information, it should raise a red flag as to the professionalism of your advisor, or lack thereof, and how he determined that the advice he has provided to you is suitable and prudent for you – based on your best interests or on the compensation he could receive.

When it comes to the question of suitability/prudence of actively managed mutual funds, the Restatement (Third) Trusts provides investors and investment fiduciaries with a simple test which incorporates the forensic standards discussed herein. After noting the additional costs and risks generally associated with actively managed funds, the Restatement simply states that

These added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves decisions by the trustee that gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…

I would strongly suggest the use of the four questions by both plan fiduciaries and plan participants, in fact investors in general, as the cornerstone of their own due diligence process. .  The questions can provide the transparency needed to properly evaluate a plan’s available investment options

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

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, BICE, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investments, IRA, IRAs, prudence, retirement plans, RIA, RIA Compliance, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Sleeping With the Enemy: DOL’s Betrayal of Plan Participants and Retirees

Posted on August 29, 2017 by jwatkins

Despite promises made during election campaign, the Trump administration has predictably chosen to side with big business over the interests of consumers. The regulators responsible for protecting the public against the abusive practices of the investment industry have increasingly become little more than shills for the very industries they are supposed to be regulating, eagerly adopting and promoting every disingenuous argument put forth by the industry to deny investors much needed protections.

The securities industry has requested that complete implementation of the Department of Labor’s (DOL) fiduciary rule be delayed for an additional eighteen months based on claims that they are not ready for the new rules.  I previously addressed the lack of merit in such claims in a previous post. As expected, the DOL formally submitted a request to the Office of Management and Budget for such extension and the OMB has just approved the request.

While the investment industry publicly claims lack of readiness to incorporate the DOL’s new fiduciary rule into their business, insiders claim that the industry’s real motivation is :to delay or totally eliminate the class action provisions of the DOL’s rule, to deny plan participants access to the court system and full discovery rights. The fact that the DOL has suggested to a court that it will most likely consent to the investment industry’s objection on this matter is very interesting given the express language in ERISA regarding its purpose

It is hereby declared to be the policy of this chapter to protect…the interests of participants in employee benefit plans and their beneficiaries…by establishing standards of conduct, responsibility, and obligation for fiduciaries of employee benefit plans, and by providing for appropriate remedies, sanctions, and ready access to the Federal courts.(emphasis added) 29 U.S.C. § 1001(b)

So the DOL has consciously chosen to ignore the clear mandate of ERISA, choosing instead to promote and protect the interests of the industry it is supposed to regulate instead of honoring the Department’s expressed mission statement or promoting and protecting the best interests of American workers and pension plan participants, including the express right to access to the courts.

As an attorney, I cannot help but remember the wise words of the court in Norris & Hirshberg v. SEC (177 F.2d 228, 233). Facing a similar situation, the court rejected the dingenuous arguments of a broker-dealer seeking protection from the court, the court stating that

To accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protection of the broker-dealer rather than for the protection of the public….On the contrary, it has long been recognized by the federal courts that the investing and usually naive public need special protection in this specialized field.

The same position can, and should, be adopted by the DOL, especially in light of the documented evidence of the abusive practices that the investment industry has engaged in in connection with the pension and retirement industries. ERISA was, and still is, intended to provide for the protection of American workers, not the investment industry.

Congress is also actively engaged in efforts to deny American workers and pension plan participants the much needed protections provided to them under the DOL’s new fiduciary rule, despite the fact that the investment industry has failed to produce any legally admissible evidence to support its ‘doom and gloom” claims against the DOL’s fiduciary rule.

With both the executive and legislative branches deserting them, the public can only look to the judicial branch to uphold the law and protect them against the investment industry’s abusive practices. Most courts have recognized the problem and become the sentinels for enforcing the law.

Sadly, some recent court decisions are troubling, as they reflect either a lack of a basic understanding of ERISA’s goals and purposes, as well as investment industry practices that brought about the DOL’s new fiduciary rule. In recent decisions, the courts have seemingly ignored or overlooked one of the primary goals and purposes of ERISA, to help workers work toward accumulating sufficient assets for retirement, by ignoring the financial impact of overpriced and underperforming mutual fund options within pension plans.

In some recent decisions, the courts have focused entirely on the absolute level of fees of actively managed mutual fund options within a plan, an approach the investment industry has constantly opposed. As the investment has pointed out, the focus should be on a fund’s fees relative to the benefit provided by the fund.

Unfortunately for the investment industry, the history of actively managed mutual funds has consistently shown a pattern of overpricing and underperformance relative to comparable passively managed/index mutual funds. This irrefutable evidence makes the recent court decisions supporting actively managed funds even more troubling.

Section 90, comments h(2) and m, of the Restatement (Third) Trusts states that a choice to due to the added costs and risks generally associated with actively managed mutual funds, such funds should only be chosen when it can reasonably be assumed that actively managed fund will produce sufficient benefits to offset such added costs. As mentioned earlier, the majority of actively managed funds cannot meet this requirement. The courts’ decisions seemingly either ignored or overlooked this crucial fact, a fact that indicates that most actively managed mutual funds do not help to promote a plan participant’s ‘best interests” or retirement readiness.

Conclusion
As the investment industry, the DOL and Congress all work to deny plan participants much needed protections against the proven abusive marketing strategies of the investment industries, one can hope that litigation will eventually result, with an informed court stepping forth to protect pension plan participants, including preserving the right of plan participants to access to the court through class-action suits where appropriate, as set out in ERISA. In stepping forth to protect plan participants, such court need only look to the analogous recognition and admonition of the problem by the court in Archer v. S.E.C (133 F.2d 795, 803), where the court stated that

The business of trading in securities is one in which the opportunities for dishonesty are of constant recurrence and ever present. It engages acute, active minds trained to quick apprehension, decision and action. The Congress has seen fit to regulate this business.

The same conditions that necessitated the enactment of ERISA are still present today and even more insidious as plan participants and retirees are fleeced of their life savings. Based on current indications, an enlightened judiciary may be the last hope for American plan participants and retirees.

Posted in 401k, BICE, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, pension plans, retirement plans | Tagged , , , , , , , , , , , | Leave a comment