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

Posted on March 4, 2019 by jwatkins

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

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

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

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

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

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

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

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.4

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

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

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

(b) ERISA section 404(c) plans –

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

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

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

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

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

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

(2) Opportunity to exercise control.

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

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

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

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

(3) Broad Range of Investment Alternatives

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

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

(B) Choose from at least three investment alternatives:

(3) Broad range of investment alternatives

(1) Each of which is diversified;

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

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

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

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

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

Control costs. Minimize the risk of large losses.

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

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

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

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

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

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

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

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

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

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

Markowitz correctly described effective diversification:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, closet index funds, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , | 1 Comment

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

Posted on February 22, 2019 by jwatkins

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

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

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

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.’1

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

When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.2

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

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

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

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

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

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

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

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

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

  • A fiduciary has a duty to be cost-conscious. (cmt. a)
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.(cmt. f)
  • Actively managed mutual funds that are not cost-efficient are imprudent. (cmt. h(2).9

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

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

[R]ather than explicitly enumerating all of the powers and duties of trustees and other fiduciaries, Congress invoked the common law of trusts to define the general scope of their authority and responsibility.”11

Thus a federal common law based on the traditional common law of has developed and is applied to define the powers and duties of ERISA plan fiduciaries….12

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

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

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

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.13

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

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.15

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

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

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

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

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

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

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

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

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

[c]ourts] objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions. [ERISA’s] test of prudence …is one of conduct, and not a test of performance of the investment. Thus, the appropriate inquiry is ‘whether the individual trustees, at the time they engaged in the challenged transactions, employed the appropriate methods to investigate the merits of the investment and to structure the investment.19

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

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

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

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

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

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

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

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

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

The First Circuit seems to agree with General Schwarzkopf.

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

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

Notes

1.Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018)
2. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law(1976). (Faculty Scholarship Series: Paper 498) available online at http://digitalcommons.law.yale.edu/fss_papers/498
3. Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009) (Hecker II).
4. Restatement (Third) Trust, Section 90, cmt. h(2). (American Law Institute)
5. Brotherston.
6. H. R. Rep. No. 93-533, at 11; S. Rep. no. 93-127, at 29 (1973).
7. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
8. Restatement (Third) Trusts, Section 90. (American Law Institute)
9.Restatement (Third) Trust, Section 90, cmt. a, f, and h(2). (American Law Institute)
10. In re Enron Corp. Securities, Derivatives, and “ERISA” Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003) (Enron).
11. Enron, 546.
12. Enron, 546.
13. Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e
14. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
15. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
16. 29 U.S.C. § 1104(a)(1)(B).
17. Enron, 547.
18. DiFelice v. U.S. Airways, 497 F.3d 410, 423, fn. 8 (4th Cir.)
19. Enron, 548.
20. Enron, 548.

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

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

Posted on February 5, 2019 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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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