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

Posted on February 5, 2019 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  • A fiduciary has a duty to be cost-conscious. (cmt. a)
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.(cmt. f)
  • Actively managed mutual funds that are not cost-efficient are imprudent. (cmt. h(2))10

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

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

“Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.” 11

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

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.13

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

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

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

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

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

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

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

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

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.’16

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

When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify. 17

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

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

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

Notes

  1. Shaw v. Delta Airlines, Inc.,  463 U.S. 85, 90, 103 S. Ct. 2890, 77 L. Ed. 2d 490 (1983).
  2. Hirshberg & Norris v. SEC, 177 F.2d 228, 233 (1949)
  3. Donovan v. Bierwirth, 716 F.2d 1455, 1467 (5th Cir. 1983).
  4. Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009) (Hecker I)
  5. Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009) (Hecker II)
  6. Pfeil v. State Street Bank & Trust Company, 671 F.3d 585, 587, 597-98 (6th Cir. 2012).
  7. Fred Reish, “Hecker v. Deere Revisited,” available online at https://www.drinkerbiddle.com/insights/publications/2009/09/hecker-vs-deere-revisited.
  8. DiFelice v. U.S. Airways, 497 F.3d 410, 423, fn. 8 (4th Cir.)
  9. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
  10. Restatement (Third) Trusts, Section 90, cmt. h(2)
  11. Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www..ft.con/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e
  12. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
  13. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
  14. Available online at http://www.johnbogle.com
  15. Charles D. Ellis,“Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (McGraw-Hill Education: New York, NY), 2018, 163-164. 
  16. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018)
  17. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law (1976). (Faculty Scholarship Series: Paper 498) available online
    at http://digitalcommons.law.yale.edu/fss_papers/498.

 

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

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

Posted on January 16, 2019 by jwatkins

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

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

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

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

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

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

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

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

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

But why?

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

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

  • A fiduciary has a duty to be cost-conscious.2
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk, or conversely, funds that offer the lowest level of costs and risk for a given level of return.3
  • Actively managed mutual funds that are not cost-efficient are imprudent.4

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

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

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

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

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

AMVR Cost-Efficiency Analysis of CREF Stock Account R3

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Copyright © 2019 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. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
2. Restatement (Third) Trusts, Section 90, comment b.
3. Restatement (Third) Trusts, Section 90, comment f.
4. Restatement (Third) Trusts, Section 90, comment h(2).
5. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e; Carhart, Mark, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82; Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” available at http://www.ssrn.com/ abstract=951367
6. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.
7. Carhart, supra; Malkiel, Burton, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.

Posted in 403b, closet index funds, consumer protection, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investments, pension plans, prudence, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , | Leave a comment

2019: The Battle of the “Best Interests” – Part Deux

Posted on January 1, 2019 by jwatkins

The Chinese calendar designates each year in terms of an animal. I am not sure what the animal is for 2019. However, for the investment industry, 2019 clearly represents the continuation of the battle of the “best interests” between consumers and the investment industry on both the brokerage and pension plan fronts.

Reg BI
On the brokerage front, both consumers and the investment industry await the final version of the SEC’s proposed Regulation “Best Interest’ (Reg BI). Under Reg BI, a broker-dealer and its registered representative would be required

to act in the best interest of the retail customer at the time[any] recommendation is made without placing the financial or other interest of the broker, dealer, or [registered representatives] ahead of the interest of the retail customer.

Various FINRA/NASD and SEC enforcement actions have held that a broker must always act in the best interests of a customer. Those same actions have stated that a broker violates that duty when they place their own financial interests ahead of a customer’s financial interests.

A key provision of Reg BI is the regulation’s Care Obligation requirements. The Care Obligation would require a broker-dealer, “when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, to exercise reasonable diligence, care, skill, and prudence.”

The Care Obligation essentially tracks the requirements of FINRA Rule 2111, otherwise known as FINRA’s suitability rule. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.

This similarity is exactly what has caused concern among consumer protection advocates. Such groups would prefer the stronger protections provided by a classic fiduciary standard, including the duties of loyalty and prudence.

The SEC’s refusal to simply adopt the same fiduciary standard required of RIAs under the ’40 Act is puzzling given the fact that Reg BI expressly includes a duty to exercise prudence in making recommendations. Simple common sense necessarily results in the following question-how can an investment be said to be in a customer’s best interest unless it also deemed prudent?

401(k)/403(b) Litigation
2018 saw a continuation of litigation involving alleged excessive fees and/or breach of fiduciary duties within 401(k) and 403(b) plans. While there was a mixture of both settlements and dismissals of such cases, a number of the dismissals were reversed on appeal or are still involved in the appeal process.

There were two reversals that are still involved in the appeal process that could have a significant impact on the defined contribution industry, as they will finally result in uniform standards for 401(k) and 403(b) plans. In Brotherson v. Putnam, the key issue is who has the burden of proof on causation in defined contribution actions once the plaintiff/plan participants prove that the plan sponsor violated their fiduciary duties and that damages were sustained. The First Circuit Court of Appeals reversed the lower court’s decision and ruled that a plan sponsor has the burden of proof on the issue of causation given the fact that the a plan sponsor has the information required to disprove the plaintiff’s evidence.

Putnam appealed to SCOTUS and they accepted the case, arguably to end the split in opinion within the federal appellate courts. If SCOTUS upholds the First Circuit’s decision, it could create an almost impossible burden on plan sponsors and plan advisers given the strong evidence of excessive fees and the consistent underperformance of actively managed mutual funds relative to index funds.

John Langbein was the Reporter for the committee that wrote the Restatement (Third) of Trusts (Restatement). In 1976, shortly after the Restatement was released, he and fellow law professor Richard Posner wrote an article asking whether fiduciaries had a legal duty to “buy the market,” to buy index funds. They concluded that fiduciaries could no longer ignore the evidence and blindly continue to place money in managed accounts.

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

That day has come. Not surprisingly, comment h(2) to Section 90 of the Restatement, a section commonly known as the Prudent Investor Rule, also states that actively managed mutual funds that are not cost-efficient are imprudent  SCOTUS will now essentially answer the question posed by Langbein and Posner over forty years ago.

The second key case involves the question of whether a plan participant can even bring an action against their 401(k)/403(b) plan. Under ERISA, a plan participant generally has six years to bring an action against their plan. That time limit is shortened to three years if the plan participant had “actual knowledge” of the plan sponsor’s violations.

While “actual knowledge” seems pretty clear, that is not the case in the courts. The federal appellate courts are split on the issue. In Sulyma v. Intel Corporation, the Ninth Circuit recently reversed a lower court and ruled that “actual knowledge” meant just that, that “constructive knowledge” was not sufficient. The Ninth Circuit remanded the case back to the lower court for further consideration. Given the split in the federal appellate courts on such an important issue, it would not be surprising to see this case go to SCOTUS in order to establish a uniform standard.

Conclusion
While 2018 was a memorable year in terms of the battle of best interests between investors and the investment industry, 2019 could turn out to be even more memorable, with the implementation of Reg BI and establishment of two much-needed uniform standards regarding pension plans duties and plan participants’ corresponding rights.

And lurking in the background is the suggestion that 2019 could be the year that pension plans attempt to recover from plan advisers some, if not all, of the money lost in excessive fees and/or breach of fiduciary cases resulting from their adviser’s poor advice. While plan advisers typically include language to insulate themselves from any fiduciary liability for advice provided to plans, it has been suggested that “there is more than one way to skin a cat.”

Happy New Year!

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, best interest, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, Reg BI, retirement plans, RIA, SEC | Tagged , , , , , , , , , , , , , , , , | Leave a comment

Just a Thought: Is 401(k) Chaos Coming?

Posted on December 4, 2018 by jwatkins

The 1st Circuit just handed down what in my opinion is one of the best well-reasoned and well-written opinions I have read in my 36 years of practicing law. If you practice in the 401(k)/403(b) arena, you should do yourself a favor and read it. It’s long, 50 pages, but if SCOTUS upholds the decision, it will result in significant changes in ERISA pension plans. Putnam clearly  understand  the potential ramifications for both the 401(k)/401(b) and actively managed mutual funds. You can find the decision here.

I’m currently working on a law review journal article on the potential synergy between SCOTUS adopting the 1st Circuit’s reasoning, which I expect, and the SEC’s proposed Reg BI. I’ve been soliciting various viewpoints from ERISA and securities attorneys as to my theories and strategies. So far the “yeas” significantly lead the “nays.” My concern is that many in the ERISA arena are not going to be ready if my scenarios do come true.

The SEC has steadfastly refused to use the term “fiduciary” in referencing Reg BI. Practically speaking, I’m not sure it will matter in the end, as the plaintiff’s bar can argue, with merit, that call it what you will, a fiduciary duty will apply.

I believe the plaintiffs’ argument would, and should, be based on the following argument:

1. FINRA is on as saying that their suitability standard is “inextricably intertwined” with the “best interests” standard. (FINRA Regulatory Notice 12-25)
2. NASD, FINRA and SEC enforcement decisions have consistently ruled that

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 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, 2003 SEC LEXIS 1154, at *11 (2003)

The SEC’s special study of broker-dealers and RIAs agreed, stating that

[A] central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer.  SEC Staff Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, at 59 (Jan. 2011)

3. It is never in the best interests of a customer/client to waste money. (UPIA, Section 7)
4. A fiduciary has a duty to be cost-conscious. (Restatement (Third) Trusts, §90, cmt. b)
5. Due to the higher costs and risks generally associated with actively managed mutual funds, the use or recommendation of such funds is never in a customer’s/client’s best interests unless it can be objectively expected that the fund will produce commensurate incremental returns to cover such incremental costs. (Restatement (Third) Trusts, §90, cmt. b)

Whenever I have presented this to a stockbroker or to the personnel of a broker-dealer, the immediate response is “we are not fiduciaries and are not held to the prudence standard.” My response-“Explain how any investment recommendation can ever meet a “best interest” standard if the recommendation is not prudent?” As we all know, “prudence” is part of the fiduciary standard. I cannot wait to hear that debate.

That debate has already been contemplated and addressed:

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge. – Charles Ellis

There is stong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs. -Philipp Meyer-Brauns

My proprietary metric, the Active Management Value Ratio™ 3.0, provides a means for plan sponsors, plan participants, courts and attorneys to document such issues, both on a nominal and an Active Expense Adjusted aka closet indexing) basis.

Restatement (Third) Trusts, §90, cmt h(2) is what should have most plan sponsors and ERISA fiduciaries concern, especially after reading the 1st Circuit’s Putnam decision. Putnam’s decision to appeal to SCOTUS was much-needed to resolve the key issue presented by the appeal-once an ERISA plaintiff establishes both the breach of fiduciary duty and a loss, who has the duty to establish the causation issue.

There is currently a three-way split between the eleven circuits of the federal courts of appeals. Justice for a pension  plan participant in an ERISA-covered plan should never depend on where they live.

The parties that should be most interested in the Putnam appeal are the plan sponsors and other the plan’s other fiduciaries. Most advisory contracts have provisions hidden in them that insulate the plan advisory from any liability that the plan’s advisor provides. Based on my experience, most plan sponsors are unaware of this provision until it is too late.

If SCOTUS upholds the 1st Circuit’s decision, and a plan’s advisory contract contains that clause insulating the advisor from liability, it will then fall solely on the plan sponsor to prove that it was prudent in the selection of their  plan’s investment options. Based on h(2), current data and research to date, in most cases they will simply not be able to do so, resulting in full liability, including unlimited personal liability for a plan’s fiduciaries.

Even if a plan’s advisors have the liability insulation clause in their advisory contract with a plan, I would not necessarily rest easy. Plaintiff’s attorneys are increasingly naming plan advisors as party plaintiffs in their complaints. In most cases to date, that strategy has not been successful, but legal policy can change, as evidenced by the Putnam case itself.

If you are in any way involved in the ERISA arena, I would read the 1st Circuit’s decision and proactively monitor the case as it proceeds through SCOTUS.

Posted in 401k, 401k compliance, 401k investments, 404c compliance, closet index funds, compliance, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, SEC, securities compliance, wealth management | Tagged , , , , , , , , , , , , , , , , , | Leave a comment

Why the SEC Will Never Enact a Meaningful Fiduciary Standard

Posted on October 12, 2018 by jwatkins

I continue to enjoy reading analyses on the SEC’s BI proposal. These are analyses from industry leaders, people who I greatly admire and respect. When people ask my opinion, I just tell them it  is all just a cruel game, that the SEC has never intended to protect the public with a meaningful universal fiduciary standard, that the SEC will never do so, as it would jeopardize their own careers and risk incurring the wrath of Wall Street. Don’t believe me?

  1. In the Tibble decision, SCOTUS recognized the Restatement (Third) Trusts (Restatement) as the go-to resource for the legal system in addressing fiduciary issues, especially those involving ERISA
  2. Restatement Section 90, cmt. b, states that fiduciaries have a duty to be cost-conscious.
  3. Restatement Section 90, cmt. f, states that fiduciaries have a duty to seek the investment with the highest return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of return.
  4. Restatement Section 90, cmt. h(2), states that it is imprudent for fiduciaries to use or recommend actively managed mutual fund unless the reasonably expected return from such fund will cover the extra costs and risks typically associated with such funds.

The last item is the key, as most actively managed funds simply are not cost-efficient if analyzed properly. If the potential closet indexing factor is considered by analyzing a fund’s incremental costs in terms of Ross Miller’s Active Expense Metric, the number of cost-efficient actively managed funds drops to well below under 10 percent.

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.1

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.”2

“there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.3”

Want more evidence? Each year “Pensions & Investments” publishes a list of the top mutual funds within U.S. defined contribution plans, based on total amounts invested such plans. Each quarter I update the top ten non-index funds from said list. My scoring is based on the funds’ risk-adjusted returns (the same returns used by Morningstar in calculating their “star” system, the same “star” system funds and advisers use in their marketing programs) and each fund’s Active Expense Rating, in order to penalize funds with high closet indexing scores. The 3Q results are available at Slideshare.

Variable annuities are definitely neither cost-efficient nor prudent. Milevsky’s famous study put that argument to rest forever.

The SEC is never going pass a meaningful fiduciary standard to protect the public, no matter how badly such a measure is needed. I wish they would prove me wrong, but I am not holding my breath. They have to protect their own best interests, the revolving door to Wall Street and the big paydays. To do that, “the wise owl does not (poop) in its own nest.”

Notes
1. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e.
2. Ellis, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018, 10.
3. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.

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.

Posted in closet index funds, consumer protection, cost consciousness, cost efficient, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, prudence, SEC | Tagged , , , , , , , , , , | 1 Comment

The Case for Liability-Driven Investing

Posted on October 6, 2018 by jwatkins

I was recently interviewed by Robin Powell for “The Evidence-Based Investor,” a U.K.-based blog. Robin is a highly respected journalist and one the leaders of the evidence-based investment movement. The topic of our discussion was the investment litigation trend in the U.S., especially ERISA-based litigation. Click here to read the interview.

I think I may have caught Robin a little off-guard when I told him that I expected securities related litigation, both ERISA and non-ERISA related litigation, to increase. As I explained to Robin, I think we are going to see the plaintiff’s bar focus more on the fiduciary standards set out in the Restatement (Third) of Trusts (Restatement), specifically Section 90, aka the Prudent Investor Rule.

As I have previously posted, a number of courts have recently dismissed ERISA actions involving allegations of excessive fees and/or breach of plan sponsor fiduciary duties. In my opinion, a number of the dismissals were based on very questionable grounds if one relies on the fiduciary standards established by the Restatement.

I believe that the plaintiff’s bar can strengthen their cases and possibly prevent such questionable dismissals by focusing on Section 90, comment h(2). Comment h(2) essentially states that the use or recommendation of an actively managed mutual fund is imprudent unless the fund is cost-efficient. This position is a follow-up to Section 90, comment b, which states that fiduciaries have a duty to be cost-conscious.

People that follow me know that I am an unabashed advocate of the Restatement and its fiduciary standards. In most cases, the Restatement is simply a codification of common sense. For that reason, I firmly believe that most of the standards set out in Section 90 are arguably applicable in non-fiduciary investment situations.

One such example is the cost-efficiency requirement. A fund that is not cost-efficient means that the fund’s incremental costs exceed its incremental return, resulting in a net loss for an investor. Losing money in clearly the antithesis of a prudent investing.

John Langbein was the Reporter for the committee that wrote the Restatement in 1972. A law professor at Yale University, he co-wrote an excellent law review article discussing the new standards of prudent investing as set out in the new Restatement. One of the questions posed by the article was whether investment fiduciaries had “a duty to buy the market,” aka index funds.

We begin with the question whether trust law would permit the trustee to implement the lessons of capital market research and adopt a buy-the-market investment strategy. We think we should conclude our review of the trust law by warning fiduciaries that they cannot “play safe” by ignoring the new leaning and continuing uncritically to put trust money into old-fashioned, managed portfolios. When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, court may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.

That advice was as valid in 1976, when the article was originally written, as it is today. The combination of that commentary and the Restatement’s cost-efficiency requirement make a strong and compelling argument for indexing, especially given the fact that evidence shows that very few actively managed mutual funds are cost efficient.

As always, I simply offer this information to plan sponsors and other investment fiduciaries to consider in hopes of avoiding unwanted and unnecessary professional liability exposure.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c compliance, cost consciousness, cost efficient, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , | Leave a comment

May It Please the Court: Vanguard Funds As ERISA Benchmarks Study

Posted on September 23, 2018 by jwatkins

InvestSense – The art of combining sound, proven investment strategies with common sense.

I recently posted an article on one of my blogs discussing my concerns over some of the reasons given by some courts for dismissing actions against 401(k) and 403(b) plans. The actions basically alleged that the plans had charged excessive fees and/or had chosen imprudent investment options for plan participants.

One of the specific decisions I discussed involved a judge refusing to accept Vanguard funds as acceptable benchmarks to evaluate a plan’s actual investment options. My objection was with the court’s refusal to accept the Vanguard funds based purely on the fact that their low-fee business model is different from most actively managed funds, which are for-profit models that charge significantly higher fees, yet consistently underperform comparable Vanguard fees.

[the expert’s] comparison, however, is flawed. Vanguard is a low-cost mutual fund provider operating index funds “at-cost.” Putnam mutual funds operate for profit and include both index and actively managed investment. [The expert’s] analysis thus compares apples and oranges. Moreover, even if the Court were to accept the Plaintiffs’ account of the range of Putnam mutual fund expense ratios or average management fees, the Plaintiffs cite no relevant case law holding that such ranges or averages are unreasonable as matter of law.1   

As I stated in my post, the court’s “apples and oranges” argument completely ignores the fact that the whole purpose of retirement plans is to provide plan participants with legally prudent investment options in hopes of allowing them to become “retirement ready.” ERISA, the primary law covering most retirement plans, and the Restatement of Trusts both impose strong legal duties on plan sponsors, including a duty of loyalty to plan participants and a duty to select prudent investment options for a plan.

One of the legal duties set out in the Restatement is that a defined contribution plan’s actively managed investment options be cost-efficient, that the reasonably projected returns of each actively managed investment within a plan will cover the costs and risks associated with that investment.2 Most 401(k) and 403(b) plans still select actively managed mutual funds as their investment options. And yet, the evidence clearly shows that most actively managed mutual funds fail to meet this requirement, with studies noting that

“the investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.3

“there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4”

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.”5

If the plan participants’ best interests are truly what matters, then how do all the actively managed mutual funds measure up to comparable Vanguard benchmark funds? Using the Morningstar Data Research Center, I ran screens on each of the nine investment styles that Morningstar uses in analyzing the mutual fund universe: LCB, LCG, LCV, MCB, MCG, MCB, SCB, SCG, SCV.

Most of the criteria I used in the screens are based on a simple metric I created a couple of years ago, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is based largely on the studies of investment icons Charles D. Ellis and Burton Malkiel:

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.6 – Charles D. 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.7
Burton G. Malkiel

The screens were intended to evaluate relative performance, cost-efficiency, and potential “closet indexing” issues. The screens reflect the progressive  result after the application of each screen element.

The Screens Results
LCB – 1294 funds
Benchmark: Vanguard S&P 500 Index Fund-Admiral shares (VFIAX)
5-Year Performance > 74
Expense Ratio < 6
Turnover < 1
R-squared < 90 1 (VFIAX)

LCG –  1387 funds
Benchmark: Vanguard Growth Index Fund-Admiral shares (VIGAX)
5-Year Performance > 387
Expense Ratio < 2
Turnover < 2
R-squared < 90 2 (VIGAX and Vanguard Growth Index Fund-Institutional shares)

LCV –  1176 funds
Benchmark: Vanguard Value Index Fund-Admiral shares (VVIAX)
5-Year Performance > 32
Expense Ratio < 2
Turnover < 2
R-squared < 90 2 (VVIAX and Vanguard Value Index Fund-Institutional shares)

MCB –  422 funds
Benchmark: Vanguard Midcap Index Fund-Admiral shares (VIMAX)
5-Year Performance > 50
Expense Ratio < 4
Turnover < 4
R-squared < 90  4 (Vanguard Midcap Index Fund-Admiral, Institutional and InstitutionalPlus shares; Fidelity Midcap Index-Institutional shares)

MCG –  581 funds
Benchmark: Vanguard Midcap Index Growth Fund-Admiral shares (VMGMX)
5-Year Performance > 237
Expense Ratio < 2
Turnover < 1
R-squared < 90 1 (VMGMX)

MCV –  398 funds
Benchmark: Vanguard Midcap Index Value Fund-Admiral shares (VMVAX)
5-Year Performance > 24
Expense Ratio < 1
Turnover < 1
R-squared < 90 1 (VMVAX)

SCB –  744 funds
Benchmark: Vanguard Small Cap Index Fund-Admiral shares (VSMAX)
5-Year Performance > 99
Expense Ratio < 3
Turnover < 3
R-squared < 90  3 (Vanguard Small Cap Index Fund-Admiral, Institutional and Investor shares)

SCG –  702 funds
Benchmark: Vanguard Small Cap Growth Index Fund-Admiral shares (VSGAX)
5-Year Performance > 307
Expense Ratio < 2
Turnover < 2
R-squared < 90  2 (VSGAX and Vanguard Small Cap Growth Index Fund-Institutional shares)

SCV –  398 funds
Benchmark: Vanguard Small Cap Value Index Fund-Admiral shares (VSIAX)
5-Year Performance > 18
Expense Ratio < 2
Turnover < 2
R-squared < 90  2 (VSIAX and Vanguard Small Cap Value Index Fund-Institutional shares)

Pretty impressive showing by Vanguard’s fund if “retirement readiness” and the “best interests” of plan participants is the true evaluation standards for the fiduciary duties of loyalty and prudence. As a fiduciary attorney, the results of the study remind me of the prediction made by John H. Langbein, who served as the Reporter of the committee that authored the Restatement (Third) of Trusts:

We think we should conclude our review of the trust law by warning fiduciaries that they cannot ‘play safe’ by ignoring the new learning and continuing uncritically to put trust money into old-fashioned, managed portfolios. When market funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantages for the beneficiaries of his trust may in the future find his conduct difficult to justify.8

It is a liability/risk management question that plan sponsors, investment advisers, and other investment fiduciaries should consider. To quote Aldous Huxley, “facts do not cease to exist because they are ignored.”

Notes
1. Brotherson et al. v. Putnam Investments, Inc., available online at http://www.investmentnews.com/assets/docs/Cl10985646.
2. Restatement (Third) Trusts, Section 90, comment h(2).
3. Carhart, Mark, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
4. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.
5. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e.
6. Ellisa, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018, 10.
7. Malkiel, Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
8. Langbein, John H. and Posner, Richard A., “Market Funds and Trust-Investment Law, (1976), Faaculty Scholarship Series. Paper 498. http://digitalcommons.law.yale.edu/fss_papers/498

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

Fundamental Unfairness: Inequitable and Inconsistent Interpretations of ERISA

Posted on September 4, 2018 by jwatkins

As I mentioned in an earlier post, a number of recent decisions dismissing 401(k)/403(b) excessive fees/breach of fiduciary duties actions have highlighted the issue of fundamental fairness in the courts involving ERISA issues. The recent dismissal of the Checksmart action is a perfect example of the judicial/ERISA issues.1

The plaintiff made the typical allegations of excessive fees and breach of the fiduciary duty of prudence. The court dismissed the plaintiff’s action, applying the three-year statute of limitations based on the court’s interpretation of ERISA’s “actual knowledge” of the plan sponsor’s alleged breaches.

The court stated its position that

‘actual knowledge’ really means ‘knowledge of the underlying conduct giving rise to the alleged violation’ rather than ‘knowledge that the underlying conduct violates ERISA.’2

The court then held that the three-year statute of limitations began to run when the plan advised plan participants of the funds’ expense ratios.

There are presently three different interpretations of the “actual knowledge” standard within the federal court system. The actual text of the three-year statute of limitations states as follows:

No action may be commenced under this subchapter with respect to a fiduciary’s breach of any responsibility, duty, or obligation under this part, or with respect to a violation of this part, after the earlier of—

(2) three years after the earliest date on which the plaintiff had actual knowledge of the breach or violation;…3

On its face, taking the words at their common meaning, the three-year statute of limitations would seem to require actual knowledge of the breach or violation. As I discussed in my last post, the law is well-settled that a fiduciary relationship

creates [a] climate of trust in which facts that would ordinarily require investigation may not excite suspicion, and the same degree of diligence is not required.4

As respected ERISA attorney Fred Reish pointed out in his testimony before the DOL, most plan participants lack the knowledge of and experience with basic investment fundamentals to effectively manage their retirement accounts. And yet, the Checkmart court placed that burden on plan participants.

The clear inequity of such a position was recognized in the Hecker II court’s decision, as the court stated that the sheer number of investment options in a plan does not insulate a plan sponsor from potential liability for a breach of their fiduciary duties. As the court pointed out,

it could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives.5

As noted, there are currently three different interpretations of ERISA’s “actual knowledge” statute of limitations standard. Some of the courts, like the Checksmart court, only require that a plan participant have knowledge of the underlying the transaction creating the violation, but not that a violation has occurred. Other courts require that a plan participant have actual knowledge of the transaction and the fact that it constitutes a violation of ERISA. A third group of courts have adopted a hybrid interpretation of the “actual knowledge” requirement. For an excellent analysis of the “actual knowledge” issue, click here.

Regardless of one’s position on the “actual knowledge” requirement, the fact remains that it results in an inequitable situation where a plan participant’s ERISA protections may depend on where they live rather than the facts of their case. This a clearly inconsistent with the stated purpose of ERISA – to promote the interests of employees and their beneficiaries in employee benefit plans.

When there are such inconsistencies between the federal appellate courts involving significant laws, the Supreme Court will usually agree to hear the case and settle the issues to ensure uniformity in interpretation and applicability of the law. Hopefully, the plaintiffs in the Checksmart action will pursue that course of action to resolve this ongoing problem.

Other Unresolved Interpretation Issues
In order to ensure that ERISA is interpreted and applied consistently and equitably across all legal venues, there are other issues that need to be addressed.

The “Vanguard Funds Are Unacceptable Benchmarks” Defense
The recent Putnam 401(k) excessive fees/breach of fiduciary duties action involved the three-year statute of limitations.6 The case also involved the issue of whether Vanguard mutual funds are acceptable benchmarks for deciding breach of fiduciary duty issues. The court rejected the Plaintiff’s expert’s testimony based primarily on the difference between Vanguard’s business model and the business model of most actively managed funds, with the court stating that

[the expert’s] comparison, however, is flawed. Vanguard is a low-cost mutual fund provider operating index funds “at-cost.” Putnam mutual funds operate for profit and include both index and actively managed investment. [The expert’s] analysis thus compares apples and oranges. Moreover, even if the Court were to accept the Plaintiffs’ account of the range of Putnam mutual fund expense ratios or average management fees, the Plaintiffs cite no relevant case law holding that such ranges or averages are unreasonable as matter of law.7   

With all due respect, I would argue that these two arguments illustrate what is flawed in the current thinking in 401(k)/403(b) fiduciary breach of duty actions. If we accept the Supreme Court’s position that the purpose of ERISA is to promote the interests of employees and their beneficiaries in employee benefit plans, then a fund’s business model is totally irrelevant to the question of the prudence of a fund.

The terms “retirement readiness” and “financial wellness” are commonly referenced in ERISA circles. Those terms depend on the performance of a plan participant’s retirement account. The performance of a plan participant’s retirement account depends primarily on whether the investment options within a 401(k)/403(b) plan are cost-efficient.

Both the Restatement (Third) of Trusts (Restatement), as well as simple common sense, accept cost-efficiency as the true test of fiduciary prudence. After all, a mutual fund that is not cost-efficient results in a net loss for an investor, as it indicates that a fund’s incremental costs exceeds the fund’s incremental returns when compared to a fund with a similar objective, e.g., large cap growth, small cap value.

The court in the Citigroup case cited the significant difference in expense ratios between comparable Vanguard funds and the actively managed mutual funds in the Citigroup plan as a key reason that the court denied Citigroup’s motion to dismiss. Again, for ERISA to be meaningful, the courts must be consistent and equitable in interpreting and applying the statute.

The “Acceptable Range of Expense Ratios” Defense
If we accept the Restatement’s position as to the cost-efficiency standard for actively managed funds, then the suggestion of a legally acceptable range of annual expense fees, without consideration of the issue of “commensurate returns,” is fatally flawed. It also nullifies the notion that annual expense fees can ever be a matter of law since cost-efficiency is clearly fact specific, a matter of fact, not a matter of law. Courts may not properly grant motions to dismiss based on questions of fact, as questions of fact are exclusively the province of a jury.

There is no mention of the concept of universally acceptable ranges of expense ratios in ERISA. While a range of expense ratios may be acceptable in a particular case based upon the specific facts of that case, and the funds involved in that case may be cost-efficient, to suggest that the range of expense ratios in one ERISA action are equally acceptable in every ERISA action has no merit. The acceptability of a range of expense ratios in any case necessarily depends on the specific facts of each case.

In the second portion of the referenced Putnam quote, the court attempts to justify its decision by stating that the plaintiff failed to produce any rulings holding that the range of expense ratios in the action was unreasonable as a matter of law. The Restatement (Third) of Trusts states that the choice of actively managed mutual funds for retirement plans is only prudent if such funds can be reasonably predicted to produce commensurate returns to cover the extra costs and risks typically associated with managed funds, i.e., such funds are cost-efficient.

Studies have consistent shown that the majority of actively managed mutual funds are not cost-efficient.7 Many of those same studies state that the majority of actively managed funds fail to even cover their costs. Investment icon Charles Ellis summed it up best with his observation that

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.”8

In short, there is not, and cannot be, any universally acceptable range of expense ratios. The prudence of a mutual fund’s expense ratio is a fact-specific issue, relative to a fund’s overall cost-efficiency. It is actually very simple-if a fund is not cost-efficient, then neither the fund nor its expense ratio is acceptable under either a fiduciary prudence or suitability standard.

The “Menu of Investment Options” Defense
Courts seem to really like this argument. The argument is that even if some of the investment options within a retirement plan are imprudent, the plan provided so many other options that a plan participant could have chosen a proper portfolio. The plans and the courts usually cite Hecker v. Deere & Co. (aka Hecker I) in support of their argument.9

For some reason, supporters of this argument conveniently fail to mention the court’s subsequent ruling in Hecker II.10 The court’s decision in Hecker I created such an uproar that the court issued a “clarification,” or what many feel was actually a reversal, of their earlier “menu of options” decision. The Hecker II decision made it clear that offering a large number of investment options does not insulate the plan or the plan’s fiduciaries from liability for the imprudent selection of such plan options.

ERISA courts have consistently rejected the so-called “menu of options” defense.11 One court in particular properly nullified the “menu of options” defense, stating that

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

Much as one bad apple spoils the bunch, the fiduciary’s designation of a single imprudent investment offered as part of an otherwise prudent menu of investment choices amounts to a breach of fiduciary duty, both the duty to act as a prudent person would in a similar situation with single-minded devotion to the plan participants and beneficiaries, as well as the duty to act for the exclusive purpose of providing benefits to plan participants and beneficiaries.”12

A Proposed Solution
The current trend of some ERISA court decisions being arguably inconsistent and inequitable, effectively denying plan participants the protections guaranteed them under ERISA, is simply unacceptable. I have identified some of the problems that I feel exist. Now I would like to propose a simple solution.

People that know me know that I am a strong advocate of the fiduciary standards set out in the Restatement, especially

  • Section 90, comment b, regarding a fiduciary’s duty to control costs,
  • Section 90, comment f, regarding a fiduciary’s duty to seek the highest return for a given level of cost and risk or, conversely, the lowest cost and risk for a given level of return, and
  • Section 90, comment h(2), stating that the use or recommendation of actively managed mutual funds is imprudent unless the funds can objectively be predicted to provide returns that are commensurate with the added costs and risks, i.e., are cost-efficient

Since actively managed funds are still the predominant investment options within 401(k) plans and other types of retirement plans, a lot of the aforementioned problems could be prevented by simply adopting the Restatement’s cost-efficiency standard. Such a move would remove any subjectivity issues and would reduce the evaluation process to one simple question- is the fund cost-efficient? There is no “kinda” cost-efficient. It either is or it is not.

Adopting a cost-efficient standard would also prevent the “special” funds argument that was asserted by the defendants and accepted by the court in the NYU case. Since funds are required by law to disclose their returns and their costs, the information needed to calculate a fund’s cost-efficiency, there would be no “special” funds or special exceptions issues. The key question would simply be whether the fund in question is cost-efficient.

The investment industry and ERISA advisors would presumably oppose the adoption of a universal cost-efficiency standard. As noted earlier, most actively managed mutual funds are not, and cannot be, cost-efficient. Without even factoring in the issue of costs, Standard & Poor’s SPIVA reports consistently show that the overwhelming majority of actively managed mutual funds fail to beat their index-based benchmarks, precluding any possibility of a fund being cost-efficient.

Adopting a cost-efficiency standard would also address ERISA’s lack of an educational program requirement. An effective education requirement would allow participants to learn how to detect fiduciary beaches and imprudent investment options within their plan. That knowledge would also allow plan participants to effectively pursue “retirement readiness” and financial security, supposed goals of ERISA.

For my part, I have created several posts explaining my metric, the Active Management Value Ratio (AMVR). The AMVR is based largely on the studies of investment icons Charles Ellis and Burton Malkiel.  The AMVR allows investors, fiduciaries and attorneys to determine the cost-efficiency  of an actively managed mutual fund. The information required to calculate a fund’s AMVR is available online and only requires the basic skills of addition, subtraction, multiplication and division. I have even provided an AMVR worksheet online to simplify the calculation process. For more information about the AMVR, click here.

Conclusion
In my opinion, a number of the recent decisions dismissing 401(k)/403(b) excessive fees/breach of fiduciary duties are questionable, being based on grounds that are inconsistent with the Restatement (Third) of Trusts, a resource cited by Supreme Court as a key resource in deciding fiduciary issues, especially those involving ERISA. If ERISA is to be meaningful, then the interpretation and application of ERISA must be consistent and fair to ensure the protections enumerated in the statute.

The Restatement provides a simple and definitive standard for determining whether an ERISA fiduciary has breached their fiduciary duty of prudence in their selection of a plan’s investment options, the Restatement’s cost-efficiency standard. By adopting the cost-efficiency standard, the courts could eliminate most of the inconsistency and fairness issues that currently exist in some courts.

Notes

1.Bernaola v. Checksmart Financial, Inc., available online at  https://www.bloomberglaw.com/public/desktop/document/Bernaola_v_Checksmart_Financial_LLC_et_al_Docket_No_216cv00684_SD/2?1536004555
2. Checksmart, supra.
3. 29 U.S.C.§ 1113.
4. Johnston v. CIGNA Corp., 916 P.2d 643, 646 (1996).
5. Hecker v. Deere & Co., 569 F.3d 708, 711(7th Cir. 2009).
6. Brotherston v. Putnam Investments, LLC, available online at  https://www.bloomberglaw.com/public/desktop/document/JOHN_BROTHERSTON_and_JOAN_GLANCY_individually_and_as_representati/1?1536004808.
7. Putnam, supra.
8. Charles D. Ellis, “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e.
9. Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009).
10. Hecker v. Deere & Co., 569 F.3d 708, 711(7th Cir. 2009).
11. DiFelice v. U.S. Airways, 497 F.3d 410, 417, 418 fn. 8 423 (4th Cir. 2007) McDonald v. Edward D. Jones & Co., 2017 WL 372101; Kreuger v. Ameriprise Financial, Inc., 2012 WL 5873825; Pfeil v. State Street Bank & Trust Company, 671 F.3d 585, 587 (6th Cir. 2012).
12. Pfeil, supra, 957-598

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.

Posted in 401k, 401k compliance, 404c, 404c compliance, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , | Leave a comment

Fundamental Unfairness: ERISA Section 404(c) Is Not Working

Posted on August 28, 2018 by jwatkins

“404(c) is not working. It does not provide participants with the information they need to make informed and reasoned investment decisions…But it can work, it must work.”1

This quote came from the 2006 testimony of Fred Reish, one of the nation’s most respected ERISA attorneys, before the DOL Advisory Council. Reish went on to suggest several improvements that he felt were needed to improve ERISA section 404(c), including

  • participant investment education that focuses “on the right issues;”
  • education programs that teach ERISA fiduciaries about their fiduciary duties, including the proper selection and monitoring of plan investment options;
  • the need to provide plan participants with material and meaningful information to allow them to make “fully informed decisions” as described in Section 404(c).

With regard to the need to provide plan participants with meaningful information and the “informed decisions” promise, Reish specifically mentioned the need to provide plan participants with information that would provide them with

“an understanding of basic investment concepts-such as asset classes, correlation, strategic asset allocation and re-balancing-which most participants lack.”2

While Reish’s testimony was made in 2006, the sad fact is that the same problems exist today. Even worse is the fact that in too many instances the courts seemingly fail to acknowledge that such problems persist, that 404(c) still does not work for plan participants, their beneficiaries or plan fiduciaries. Why?

Shifting Risk to Plan Participants
Prior to the creation of defined-contribution plans, defined-benefit plans were the primary pension plans. But employers did not like defined-benefit plans because the employer bore the investment risk in such plans. Pension payments had to be made, regardless of the investment performance of the plan’s portfolio.

Defined-contribution plans are now the primary form of employee pension plans, as they allow employers to shift investment risk totally to the plan participants if certain requirements are met. In his testimony, Reish opined that based on his more than twenty-five years of experience, many 404(c) plans mistakenly believe that they are in compliance with 404(c)’s requirements. As the Enron court pointed out,

“If a plan does not qualify as a §404(c) [plan], the fiduciaries retain liability for all investment decisions made, including decisions by the plan participant.”3

Plans and the plan advisers have eagerly pointed to recent cases in which the court dismissed the plaintiff’s excessive fees and/or breach of fiduciary duty claims. Having reviewed said dismissals, I would strongly suggest that plans and plan advisers temper such celebrations, as I believe that there are valid grounds for reversing most, if not all, of such decisions..

For instance, in the recent dismissal of the NYU 403(b) action, the court decision seemed to rely heavily on the fact that the court applied the prudence standards for defined-benefit plans, even though the court openly acknowledged that the NYU plans were defined-contribution plans. There is a significant difference between the two, resulting in serious questions about the court’s entire thought process behind the court’s decision.

Since employers bore the risk in defined-benefit plans, they were given more flexibility in choosing investments for their pension plans. The prudence of investments in a defined-benefit plan is evaluated in terms of the portfolio as a whole. However, since plan participants bear the investment risk in defined-contribution plans, the prudence of the investments in a defined-contribution plan is evaluated in terms of the each individual option in the plan.

Sufficient Information to Make Informed Decisions
Section 404(c) provides that an ERISA section 404(c) plan is

an individual account plan …that (i) provides an opportunity for a participant or beneficiary to exercise control over assets in his individual account; and (ii) provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his account are invested…4

The regulation then defines the “control” requirement by stating that

a plan provides a participant or beneficiary an opportunity to exercise control over assets in his account only if:…(B) The participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed decisions with regard to investment alternatives available under the plan,…5

In discussing the importance of providing sufficient  information to 401(k) participants, the preamble to the final 404(c) regulations (“Preamble”) stressed the need

to ensure that participants and beneficiaries in ERISA section 404(c) plans have sufficient information to make informed investment decisions….[as] the investment decisions made by participants and beneficiaries in ERISA 404(c) plans will directly affect the funds available to such individuals at retirement. For this reason, participants and beneficiaries should be assured of having access to that information necessary to make meaningful investment decisions.6

Building on the importance of the provision of “sufficient information,” at least two courts have suggested that if participants are not provided with the material information necessary to protect their interests, then the participants cannot be said to have exercised the control over their 404(c) account.7.

So what constitutes “sufficient information to make an informed decision?” Two consistent themes of ERISA are cost-control and risk management. In Part I, we discussed the cost control issue and noted that the Restatement (Third) of Trusts (Restatement) states that actively managed mutual funds should not be recommended or used in trusts and plans unless they are cost-efficient.

The Importance of Effective Portfolio Diversification
With regard to risk management, various academic studies and the Restatement emphasize the value of effective diversification within a portfolio. The DOL and the courts have adopted Modern Portfolio Theory (MPT) as the accepted model for portfolio diversification/risk management.

The cornerstone of MPT is the inclusion of the correlation of returns between investments as part of the portfolio construction process. Nobel laureate Harry Markowitz, the father of MPT, has stated that

“[to] reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little protection than the uncertain return of a single security.”8

The Restatement reiterates Markowitz’s warning, stating that

“Diversification is fundamental to the management of risk and is therefore a pervasive consideration in prudent investment management.”

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

A number of courts have overlooked the significance of correlation of returns by suggesting that the sheer number of investment options within a retirement plan satisfies ERISA’s diversification requirement. Many of these courts reference the court’s decision in Hecker v. Deere & Co.,10 which suggested the “sheer number of options” theory.

However, what many attorneys and courts conveniently overlook is that the Hecker court went back and issued a “clarification” of their “sheer number” language in response to the Secretary of Labor’s strong reaction to their decision.11 The court stated that their “sheer number” language was limited to the specific facts of the Hecker case. The court went on to address the Secretary’s concerns by stating that

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.’12 (emphasis added)

There are those in the legal community, myself included, that the Hecker court’s self-described “clarification” was actually a reversal of their earlier “sheer number of investment options” position.13  And yet attorneys for the investment industry and a number of courts still try to assert the “sheer number” theory against plan participants.

The Hecker court stressed the need for plan sponsors to fulfill their fiduciary duties by properly investigating and evaluating the investments options chosen for a plan. The court also noted that that it would be inappropriate to place that burden on plan participants, to require them to detect fiduciary breaches by their plans. Since plan sponsors are fiduciaries to their plans, the Hecker court’s argument is consistent with the established legal standard that a fiduciary relationship

“creates [a] climate of trust in which facts which would ordinarily require investigation may not excite suspicion, and same degree of diligence is not required.”14

Furthermore, section 404(c) places upon a plan sponsor the affirmative duty to provide the required sufficient information to plan participants and their beneficiaries.

The DOL and the Information Tease
The DOL has released a bulletin outlining various types of investment information that may be provided to plan participants without incurring any additional fiduciary liability. Interestingly enough, the bulletin states that plan sponsors can provide generic information on general investment topics such as historical investment returns, historical investment risk and correlation of returns.15

So the DOL says plans can educate plan participants on the importance and benefits of correlation of returns information, but apparently they do not allow plans to provide plan participants with the actual correlation of returns data for the plan’s investment options, thereby denying participants the opportunity to effectively diversify their retirement accounts and minimize the risk of large losses. This would seem to be totally inconsistent with ERISA’s stated purpose, to help protect pension plan participants and their beneficiaries.16

It can, and should, be argued that correlation of return data is analogous to the historic return and risk data allowed under the DOL’s release, as such data does not advise plan participants as to which investments to choose. Correlation of returns data simply gives investors material information on which investments not to choose in order to minimize their investment risk. Again, this would seem to be totally consistent with both ERISA’s promise of “sufficient information” to allow “meaningful control” over the assets in their account, as well as ERISA’s stated purpose to help protect pension plan participants and their beneficiaries.

Plan Sponsor’s Duty to Investigate
The importance of a proper investigation of a plan’s investment options by an ERISA fiduciary cannot be overstated.

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard…..17

In determining whether an ERISA fiduciary breached their duty of prudence, the courts assess the fiduciary’s actions in terms of both procedural prudence and substantive prudence.18  In evaluating procedural prudence, the courts look at the methodology that the fiduciary used, not the eventual investment results.19  In evaluating substantive prudence, the courts base their decision on what the fiduciary knew or should have known, and how they applied, or should have applied, such information.20 An ERISA fiduciary that conducts an independent investigation and evaluation, but imprudently evaluates, selects, and monitors a plan’s investments is also guilty of breaching their fiduciary duties.21

Since the Department of Labor and the courts have adopted MPT as the standard of prudence for ERISA fiduciaries, and the key factor in MPT analysis is consideration of the correlation of returns among investments as part of the portfolio construction process, it can be argued that the failure of an ERISA fiduciary to consider the correlation of returns among the investment options being considered for their plan constitutes a breach of their fiduciary duty.  Therefore, the prudent ERISA fiduciary will always obtain and factor in the correlation of returns of the various investment options being considered as part of their plan’s portfolio selection process..

The “Sufficient Information” and “Control” Requirements
Under ERISA, an ERISA plan fiduciary is generally responsible for any losses incurred by the plan and/or plan participants that are due to the fiduciary’s failure to meet the applicable ERISA fiduciary standards.  ERISA does provide one exception to this rule if the plan qualifies as a Section 404(c) plan.

Section 404(c) provides that a plan fiduciary shall not be responsible for the losses suffered by a plan participant to the extent that such losses are due to the control of the account by the plan participant.22 While a full review of all of the requirements required to qualify as a Section 404(c) plan is beyond the scope of this white paper, I want to focus on an area that is often overlooked and, consequently, ripe for litigation.

I included the lengthy quote from the Hecker decision for a reason, specifically the statement that

“It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives.”23

I would argue that that is exactly why ERISA included the “sufficient information to make an informed decision” requirement. I would also argue that based on the unquestionable importance of correlation of returns in portfolio risk management, the failure to provide plan participants with such information effectively denies them control over their 404(c) accounts and, thus, is grounds for denial of protection under 404(c)’s safe harbor provisions.

The courts have consistently ruled that a plan participant does not have the requisite control over their 404(c) account when a plan fails to meet the “sufficient information” requirement.24 The obvious question for both plan fiduciaries and plan participants is what constitutes “sufficient information to make informed decisions.”

There are various factors that are used in determining whether a plan participant exercised the requisite control over his account.  The first question that must be addressed is whether the plan provided participants with the required broad range of investments.25  In order to satisfy the “broad range of investments” requirement, the plan must provide investment alternatives “with materially different risk and return characteristics” that allow participants to effectively diversify their investment account so as to reduce the risk of large losses, i.e., utilize MPT.26 Plan sponsors cannot be sure that they have met this requirement unless they factor in the correlation of returns between the investments chosen for their plan.

If so, the next question is “whether the plan provided the participants with ample information, including adequate information to understand and assess the risks and consequences of alternative investment options.” 27 In order to qualify as Section 404(c) plan, the plan must provide the participants with “sufficient information to make informed decisions with regard to investment alternatives available under the plan….”28 The “sufficient information” requirement is not met unless the participants is given various information, including a description of the investment alternatives available under the plan, including risk and return characteristics of each such alternative.29

Three consistent themes run through ERISA: disclosure, avoidance of large losses and the importance of controlling costs. These three requirements are imposed upon plan fiduciaries in order to further the purposes and goals of ERISA, protecting and promoting the interests of employees.

Consequently, it would only seem natural and equitable that the same information that ERISA fiduciaries need to use in fulfilling their duties should be required to be disclosed to plan participant in order to meet Section 404(c)’s “informed decisions” requirement.  Since an ERISA fiduciary should have this information in order to fulfill their duty of prudence, providing same to participants should not prove to be overburdening the plan fiduciary.

It can be anticipated that ERISA fiduciaries might object to the suggested disclosure requirement, claiming that plan service providers do not provide such information to the plan. Such objections are without merit.

As discussed earlier, ERISA fiduciaries have an obligation to conduct an independent investigation of all investment options being considered. In assessing the prudence of a fiduciary’s investigation, ERISA states that one factor is determining whether the fiduciary has given “appropriate consideration to those facts and circumstances that…the fiduciary knows or should know are relevant,”30 and that “appropriate consideration includes the composition of the portfolio with regard to diversification,” thus MPT and correlation of returns data.31

ERISA fiduciaries might also object to the suggested disclosure requirement on the grounds that ERISA does not explicitly require the disclosure of such information.  Once again, such an objection is without merit. In enacting ERISA, Congress chose to invoke the common law of trust to define the general scope of an ERISA fiduciary’s responsibilities rather than explicitly enumerate such duties.32 “Thus, [ERISA’s articulation] of a number of fiduciary duties is not exhaustive.”33

It is a well accepted principle that a fiduciary’s duty to furnish material information to a beneficiary is a fundamental concept under the common law of trusts.34 As discussed earlier, both the Restatement and ERISA would support the disclosure of such information, especially since the fiduciary should already have considered such information in assessing the prudence of the proposed investment or investment course of action.

Disclosure of such information would also be consistent with ERISA’s purposes and goals, especially since this information would prove more valuable to preventing large losses and controlling unnecessary costs and expenses than a prospectus, which few investors read or understand.  If a fiduciary does not have the education, experience and/or skill to determine the needed information on their own, then ERISA requires that they retain experts who can provide such information to the plan and its participants.35

Conclusion
In his testimony before the Department of Labor, Reish offered his opinion that

“In my experience, the vast majority of plans do not satisfy the conditions for obtaining 404(c) protection. As a result, for the vast majority of plans, the fiduciaries retain responsibility for the prudence of all investment decisions made, including participant-directed investment decisions.”36

As have outlined herein, I believe that most plan sponsors fail to comply with section 404(c)’s “sufficient information” and “control” requirements. I believe that plan sponsors must have that information in order to (1) comply with their fiduciary duty to conduct an independent investigation and evaluation of a plan’s investment options, and (2) to ensure that the plan options provide plan participant with the opportunity to effectively diversify their retirement account and minimize the risk of large losses.

I will always remember something that a plan sponsor once told me. As we discussed the importance of correlation of return data as part of a meaningful employee education program, for both plan fiduciaries and plan participants, he told me that they would never voluntarily provide plan participants with such information. When I asked him why, given section 404(c)’s requirements, his response -“because then they would know how bad our plan really is and probably sue us.”

Notes
1. “Written Comments for Testimony of C. Frederick Reish,” (Reish testimony) https://benefitslink.com/articles/guests/reish_20070920.pdf.
2. Reish testimony, supra.
3. Tittle v. Enron Corp, 284 F. Supp.2d 511, 547-48 (S.D. Tex. 2003)
4. 29 C.F.R. §§ 2550.404c-1(b)(1)(i), (ii).
5. 29 C.F.R. § 2550.404c-1(b)(2)(i)(B).
6. Preamble to 404(c) Final Regulations, 57 Fed. Reg. 46906, 46909-46910.
7. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010); In re Sprint Corp. ERISA Litigation, 388 F. Supp. 2d 1207 (D. Kansas 2004).
8. Harry Markowitz, “Portfolio Selection: Efficient Diversification of Investments”, 2d ed., (Malden, MA: Basil Blackwell Publishers, Inc., 1991), 5.
9. Restatement Third, Trusts, § 90 (Prudent Investor Rule), cmt f. Copyright © 2007 by The American Law Institute. Reprinted with permission. All rights reserved.
10. Hecker v. Deere & Co., 556 F.3d 575 (2009).
11. Hecker v. Deere & Co., (Hecker II) 569 F.3d 708, 711 (2009).
12. Hecker II, 711 (2009).
13. Fred Reish, “Hecker v. Deere Revisited,” https://www.drinkerbiddle.com/insights/ publications/2009/09/hecker-vs-deere-revisited.
14. Johnston v. CIGNA Corp., 916 P.2d 643, (1996).
15. Department of Labor Interpretive Bulletin 96-1.
16. Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 90 103 S.Ct 2890.
17. Fink v. National Sav. and Trust, 772 F.2d 951, 957 (D.C. Cir. 1985).
18. Howard v. Shay, 100 F.3d 1484, 1488 (4th Cir. 1996).
19. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983).
20. Fink, at 957.
21. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010).
22. 29 C.F.R. § 2550.404c-1(a)(1).
23. Hecker II, supra, 711.
24. Enron, at 578-79; In re AEP ERISA Litigation, 327 F.Supp.2d 812, 829 (S.D. Ohio 2004).
25. In re Unisys Sav. Plan Litigation,  74 F.3d 420, 442 (1996).
26. Unisys, at 447; 29 C.F.R. § 2550.404c-1(b)(3)(i)(A), (B)(2), (B)(4) and (C).
27. AEP, 829; Enron, at 576, 578-79.
28. 29 C.F.R. § 2550.404c-1(b)(2).
29. Unisys, at 447; 29 C.F.R. § 2550.404c-1(b)(3)(i)(B)(2).
30. 29 C.F.R. § 2550.404a-1(b)(1)(ii).
31. 29 C.F.R. § 2550.404a-1(b)(2)(ii)(A).
32. Central States, Southeast and Southwest Areas Pension Fund v. Central Transport, Inc., 472 U.S. 559, 570 (1985).
33. Glaziers & Glassworkers v. v. Newbridge Securities, 93 F.3d 1171, 1180 (3d Cir. 1996).
34. Glaziers & Glassworkers, at 1180.
35. Donovan v. Bierwirth, 680 F.2d 263, 272-73.
36. Reish testimony.

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.

Posted in 404c, 404c compliance, compliance, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, pension plans, retirement plans | Tagged , , , , , , | 2 Comments

“Fundamental Unfairness: Defined Contribution Plans and the Courts-Part I”

Posted on August 19, 2018 by jwatkins

Facts do not cease to exist because they are ignored – Aldous Huxley

Men occasionally stumble across the truth, pick themselves up and quickly
move on, as if nothing ever happened. – Sir Winston Churchill

I provide fiduciary oversight consulting services to pension plans and fellow attorneys. When a court issues a decision relating to ERISA and pension plans, I prepare an analysis of the decision and how it may affect their pension plan/litigation practice.

The courts have recently issued several decisions dismissing ERISA-based excessive fees/breach of fiduciary actions. The investment industry and plan advisers have gone online announcing that the tide has turned and such actions are a thing of the past.

To paraphrase Mark Twain, reports of the death of excessive fees/breach of fiduciary action have been greatly exaggerated. Once the courts consistently follow the applicable fiduciary standards set out in the Restatement (Third) of Trusts, I actually believe that the number of such cases will actually increase and result in more settlements or verdicts in favor in favor of plan participants. Plan sponsors should also adopt such standards into their practices to reduce their potential liability exposure.

When I take on a new consulting client, I explain my five “golden” rules, the five principles that I feel are essential to any ERISA risk management program:

  1. [ERISA] is intended to “promote the interests of employees and their beneficiaries in employee benefit plans.1
  2. The two primary duties of ERISA fiduciaries are the duty of loyalty and the duty of prudence.2
  3. The duties and responsibilities set out in ERISA are not exhaustive.3 In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts, as set out in the Restatement (Third) of Trusts (Restatement).4
  4. The use or recommendation of actively managed mutual funds is only prudent when the gains from such funds can be reasonably expected to compensate for its additional costs and risk, in other words, when the funds are cost-efficient.5
  5. Good faith does not provide a defense to a claim of a breach of one’s fiduciary duties; “a pure heart and an empty head are not enough.”6

The NYU Decision
Given my “golden” rules, the court’s recent dismissal of the excessive fees/breach of fiduciary duty action against NYU raises a number of questions. Even the court noted that it had some serious concerns given some of the facts of the case.

  1. “Fiduciary duties of loyalty and prudence” standard – Overall, the court did a good job in defining and applying the fiduciary duties of loyalty and prudence. As the court noted, the case was more about the fiduciary duty of prudence rather than the fiduciary duty of loyalty.

The court made one key misstatement of law that arguably influenced the court’s eventual decision.

Fiduciaries should consider the prudence of each investment as it relates to the portfolio as a whole, rather than in isolation.

With all due respect, while that is the standard for defined-benefit plans, it is not, and should not be, the applicable prudence standard for defined-contribution plans. This misstatement reflects a ongoing problem with the legal system not recognizing the difference between defined benefit and defined contribution plans.

The cases that the court cited in support of its mistaken “portfolio as a whole” position all involved defined-benefit plans, not defined-contribution plans. How much the court’s misstatement of the law  influenced the court’s overall analysis of the case may have to be decided by an appellate court.

In 2008, the Supreme Court finally acknowledged the crucial difference between defined benefit and defined contribution, recognizing that

[m]isconduct by the administrators of a defined benefit plan will not affect an individual’s entitlement to a defined benefit unless it creates or enhances the risk of default by the entire plan. For defined contribution plans, however, fiduciary misconduct need not threaten the solvency of the entire plan to reduce benefits below the amount that participants would otherwise receive. Whether a fiduciary breach diminishes plan assets payable to all participants and beneficiaries, or only to persons tied to particular individual accounts, it creates the kind of harms that concerned the draftsmen of §409.7

The Court then further supported its logic by pointing to ERISA section 404(c), which exempts fiduciaries from liability for losses caused by participants’ exercise of control over assets in their individual accounts. As the Court pointed out, this provision would serve no real purpose if fiduciaries never had any liability for losses in an individual account.

The significance of the difference between defined benefit and defined contribution plans in terms of plan participant risk was addressed by the court in DiFelice v. U.S. Airways.8 While the court upheld the lower court’s ruling in favor of the pension plan, the court explained the need to be careful in interpreting ERISA in cases involving defined contribution plans, especially the question of whether “investments in isolation” or “as part of the portfolio as a whole” is the applicable prudence standard.

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

This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine with a company stock fund, could theoretically, in combination, create a prudent portfolio. To adopt the alternative view would mean that any single-stock fund, in which that stock existed in a state short of certain cancellation without compensation, would be prudent if offered alongside other, diversified Funds. Any participant-driven 401(k) plan structured to comport with section 404(c) of ERISA would be prudent, then, so long as a fiduciary could argue that a participant could, and should, have further diversified his risk. This result would be perverse in light of the Department of Labor’s direction that selection of prudent plan options falls within the fiduciary duties of a plan administrator.8

Footnote eight of the DiFelice decision should be memorized by every ERISA attorney and plan sponsor, as it perfectly summarizes the reason why defined benefit plans can evaluate potential investment in terms of the portfolio “as a whole,” but defined contribution plans cannot.

The court there determined that the defendant fiduciary could properly rely on modern portfolio theory because the fiduciary himself consciously coupled risky securities with safer ones to construct one ready-made portfolio for participants. (emphasis added)

 Here, in contrast, modern portfolio theory alone cannot protect U.S. Airways, which offered [an otherwise imprudent investment option] just because it also offered other investment choices that made a diversified portfolio theoretically possible.9

The key-“one ready-made portfolio” of a defined benefit plan” as opposed to “the numerous, participant-selected accounts dependent on the investments chosen by a plan” of defined-contribution plans. There are some who will argue that footnotes do not carry the same weight as a court’s actual decision. I would argue that an attorney can absolutely take the logic set out in the footnote and successfully adopt and argue the same, especially when it is supported by common sense.

Bottom line, it would clearly be inequitable to include imprudent investment options in the limited investment options offered to defined contribution plan participants, especially when ERISA does not require that plan participants be provided with meaningful education programs that allow them to detect such imprudent investments.

The question in the NYU case is to what extent did the court’s “portfolio as a whole” position impact the court’s ultimate decision. That may be up to an appellate court to determine.

3 & 4. – ERISA not exhaustive” and “cost-efficient actively managed funds” standards
It should be noted that the court did reference the Restatement and the Prudent Investor Rule (Rule) in discussing the fact that actively managed mutual funds are acceptable investments in pension plans. However, for some reason the court failed to mention the fact that both the Restatement and the Rule clearly condition the prudent use of actively managed funds in pension plans on such funds being cost-efficient.

Restatement Section 90, comment b, states that fiduciaries have a duty to be cost conscious. Building on that duty, Section 90, comment h(2) states that

Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs, … These considerations are relevant to the trustee initially in deciding whether, to what extent, and in what manner to undertake an active investment strategy and then in the process of implementing any such decisions….Accordingly, a decision to proceed with such a program involves judgments by the trustee that gains from the course of action in question can be reasonably be expected to compensate for its additional costs and risk10

 Translated, only cost-efficient actively managed funds are appropriate for fiduciaries. Just common sense. Funds that are not cost-efficient result in net losses for an investor. As the commentary to Section 7 of the Uniform Prudent Investor Act points out, “wasting beneficiaries’ money is imprudent.”11

In reviewing recent court decisions dismissing ERISA-based actions alleging excessive fees and/or breach of fiduciary duties, there is a definite, and troubling, trend of courts arguing that there are certain ranges of annual fees which are acceptable as a matter of law. The NYU court even stated that the fees in that case were within the range of acceptable fees and that such fees were acceptable as a matter of law.

First, neither ERISA nor the Restatement (Third) of Trusts state that there is an acceptable range of annual fees for any type of mutual funds.  Second, the suggestion that there are legally acceptable ranges of random annual expense ratios based solely on a fund’s stated annual expense ratio is totally inconsistent with the standards established by the Restatement, more specifically Section 90, commonly known as the Prudent Investor Rule (Rule)

It is improper for a court to grant a motion to dismiss if there are legitimate questions of fact unresolved. In a number of the recent dismissals, the courts have claimed that courts approval of certain ranges of annual expense ratios constitute matters of law. Again, the argument that fees are prudent, without any consideration of whether the funds provide a commensurate level of return for such fees, is highly questionable, a fact the Restatement readily acknowledges.

Given the authority for requiring fiduciaries to evaluate actively managed funds in terms of their cost-efficiency, the plaintiffs’ bar should consider framing future excessive fees/breach of fiduciary duty actions in terms of the cost-efficiency standard. Such a strategy should prevent dismissals since cost-efficiency is clearly fact-specific and thus a matter of fact, not a question of law.

Proactive plan sponsors should definitely adopt such an approach in conducting their legally required independent investigation and evaluation and obtain such information, in writing, from all plan advisers. The cost-efficiency standard also (1) quantifies the prudence of an investment, (2) avoids the whole absurd argument over Vanguard funds as benchmarks, (3) removes the subjectivity often associated in fiduciary arguments, and (4) allows for prudence analyses of “unique” funds such as those at issue in the NYU case, avoiding the issue of questionable benchmarks or no benchmark at all.

5. “Pure heart and empty head” and “promote the interests of plan participants” standard
ERISA’s stated purpose is intended to promote the interests of employees and their beneficiaries in employee benefit plans. In order to do that, pension plans and their investment committees must actually be competent to provide the plan’s required service and care enough to do so properly.

In discussing the composition of the NYU investment committee, the judge noted that some of the members admitted to generally lacking the knowledge and experience to effectively serve on the committee. Some admitted to blindly accepting whatever the plans’ adviser told them, which the court noted is a violation of the law. The court also noted that one committee member was unsure if he was even a member of the committee, while another committee member indicated that she had little time for, interest in, or desire to be on the committee. The committee’s decisions clearly reflect both their overall lack of interest in their fiduciary duties and their breach of their breach of their fiduciary duties.

And yet, for some reason, at first impression, it appears the court ignored these serious “red flags.”

If the NYU court’s decision is appealed, I would anticipate the appeal to focus on

  • the court’s failure to apply the Restatement’s cost-efficiency standard for the actively managed funds in the university’s plans;
  • the appropriateness of the standards that the court did apply, e.g., absolute ranges of expense ratios as a “matter of law;”
  • the court’s application of a “portfolio as a whole” standard to the two defined contribution plan;
  • the court’s willingness to dismiss questions as to the overall composition of the plans’ investment committees and the question of whether the committees fulfilled their fiduciary duty to conduct meaningful investigations and evaluations of the plans’ investments.

Going Forward
I have received a lot of calls from both plan fiduciaries and attorneys asking me what they should do given these dismissals. Just my opinion, but I think we might see the plaintiffs’ bar starting to plead these cases relying more on the Restatement’s cost-efficiency standard in connection with the use actively managed mutual funds in pension plans..

First, it is an objective standard from a resource that the courts acknowledge and respect. Second, it will put an end to the “acceptable range of annual expense ratios” argument that plans have been arguing and, unbelievably, some courts have adopted, even though the argument is totally inconsistent with the Restatement, the legal concept of unjust enrichment, and simple common sense.  The idea that random numbers representing a range of annual expense ratios, without consideration of whether a fund provided a return commensurate level of return for such costs, simply makes no sense, a point the Restatement thankfully recognizes.

Finally, by pleading the Restatement’s cost-efficiency requirement for actively managed mutual funds, the plaintiffs’ bar should be able to effectively prevent wrongful dismissals by focusing the courts on the facts of the case, “facts” being the key word. Assuming that an action is properly plead and within the applicable statute of limitations, cost-efficiency questions are clearly dependent on the specific facts of the case, the relationship between a fund’s costs and its returns. It is improper for a court to dismiss an action when there are legitimate unresolved questions of fact.

My advice to plan fiduciaries is to be proactive and adopt the Restatement’s cost-efficient standard in performing their legally required independent investigation and evaluation of their plan’s investment options. Most plan advisers are not going to provide such information, especially since a well-known study found that most actively managed mutual funds are not cost-efficient.14 I cannot remember ever seeing a advertisement for an actively mutual fund ever touting the fund’s cost-efficiency.

Plan fiduciaries can use my free metric, the Active Management Value Ratio™ 3.0 (AMVR), to quickly and easily calculate the cost-efficiency of the funds they are considering for their plan. For information about the AMVR and a simple worksheet to perform the required calculations, click here and here.

Conclusion
As an attorney, the NYU decision is troublesome not only because of the issues I have discussed, but also because, in my opinion, it is a perfect example of the legal system’s continuing failure to recognize and respect the fundamental differences between defined benefit and defined contribution plans. Having read all of the recent decisions dismissing ERISA-based excessive fees/breach of fiduciary duty actions, not one of the decisions mentioned the Restatement’s “cost-efficiency” standard for actively managed funds.

Just like the NYU court, recent dismissal decisions have focused primarily on the returns of a plan’s funds and the idea of a “legally acceptable” range of annual expense ratios, a premise that is totally inconsistent with the Restatement’s “cost-efficient” requirement for actively managed funds.

In closing, I would strongly recommend that judges, plan sponsors and anyone involved in the defined contribution arena read the DiFelice v. U.S. Airways decision, especially footnote eight. The decision actually ruled in favor of the pension plan. However, the court took the time to address the fundamental differences and the resulting adjustments courts and ERISA fiduciaries must make to ensure that defined contribution plan participants and their beneficiaries receive the protection that ERISA was created to provide and that allows them the opportunity to become “retirement ready.”

Notes

  1. Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 90 103 S.Ct 2890.
  2. DiFelice v. U.S. Airways, 497 F.3d 410, 417, 418 fn. 8; Moench v. Robertson, 62 F.3d 553, 561 (3d Cir. 1995).
  3. Central States, Southeast & Southwest Areas Pension Fund v. Central Transport, Inc., 472 U.S. 559, 570.
  4. Tibble v. Edison Internat’l, 135 S. Ct. 1823, 1828 (2015)
  5. Restatement (Third) of Trusts, 90, cmt h(2).
  6. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th 1983).
  7. LaRue v. DeWolff, Boberg & Associates, Inc., 552 U.S. 248 (2008).
  8. DiFelice, 423-424; Langbecker v. Electronic Data Systems Corp., 476 F.3d, 303, 308 n.18; see also In re Unisys Sav. Plan Litig., 74 F.3d 420, 438-41 (3d Cir. 1996).
  9. DiFelice, 423-424.
  10. Restatement (Third) of Trusts, Section 90, cmt h(2).
  11. Uniform Prudent Investor Act, preamble to Section 7.
  12. Shaw, supra.
  13. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.

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.

 

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