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

Posted on August 28, 2018 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Restatement reiterates Markowitz’s warning, stating that

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

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

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

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

The Secretary also fears that our opinion could be read as a sweeping statement that any Plan fiduciary can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such ‘obvious, even reckless, imprudence in the selection of investments.’12 (emphasis added)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Posted on August 19, 2018 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Notes

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

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

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

 

Posted in 401k, 401k investments, 403b, 404c, 404c compliance, cost consciousness, 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 Dangers of Living in the Land of RIA Make-Believe

Posted on July 12, 2018 by jwatkins

The Seventh Circuit just ruled that a company could not enforce a mandatory arbitration clause in a contract because the company name in the contract did not match the company name trying to enforce the arbitration clause. So what does that have to do with investment advisers and financial advisers in general?

My experience has been that professionals in the investment industry tend to have big egos. They want to present the best image possible in order to gain clients and grow their AUM. Only problem is that they often violate the applicable fraud provisions because they either do not know and/or understand the applicable laws and regulations.

Case I point. An investment advisers was recently censured for violations of the anti-testimonial rules in connection with Yelp. The SEC has already addressed the issue of testimonials on social media sites. RIAs are general prohibited from using testimonials. The regulators do allow third-party ratings subject to various conditions.

I have never understood why the SEC does not crack down on all the violations I see on LinkedIn. As the referenced article points out, the fact that a site cannot or will not prevent the posting of any prohibited testimonials is irrelevant. Compliance with all applicable laws and regulations is solely the responsibility of the RIA, not the social media site.

RIA says violation was unintentional, RIA was not aware of the rule. SEC and the courts will simply cite my favorite investment related court saying-“a pure heart and an empty head are no defense.”

When a potential investor or RIA client contacts me, the first thing I do is verify that the firm legally exists. What I often find is that the firm does not actually legally exist, that the financial adviser is using what is known as a “fictitious name”, also known as a dba, or “doing business as” name. An example of a fictitious or dba name would be “John Smith dba America’s Greatest RIA Firm.”

So when I run into such as situation, the next thing I do is review the investment advisory contract the firm is using. More often than not, the contract is between a client and the firm’s fictitious name, i.e., “America’s Greatest RIA Firm.” That means the firm’s contract is void and we will be ordered to return of all fees the adviser collected on the account, with interest. I also contact the regulators to advise them that the adviser is in violation of the anti-fraud laws and regulations. This will allow other defrauded clients to get their money back.

Fictitious names are just that, a legal fiction. Since they do not actually exist legally, they cannot contact in their fictitious name. In our example, the proper disclosure in a contract would have been ” “John Smith dba America’s Greatest RIA Firm.” However, advisers using a dba do not want to properly identify the RIA because it “doesn’t look good” or is not as marketable/”makes me look small.” My advice-properly register the RIA as the form of business entity you desire, e.g., limited liability company (LLC). S-corporation, C-corporation then market to your heart’s content.

An interesting development I have seen recently are registered representatives using their broker-dealer’s RIA, which uses a fictitious name for the RIA activities, with the registered representative doing RIA business under yet another fictitious name. Double fictitious names, with all contracts and marketing using the last fictitious names. All contracts using only the fictitious names are void and clients are entitled to return of all fees paid to the non-existent firm, with interest.

When RIAs ask me what their contracts should say, I tell them just look at the name that appears on the RIA registration approval letter and make sure that that name appears on all advisory contracts and marketing materials. It’s that simple. Forewarned is forearmed.

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2Q 401(k) Top 10 Defined Contribution Funds Forensic Analysis

Posted on July 9, 2018 by jwatkins

Each quarter InvestSense, LLC, performs an updated forensic analysis of the top ten non-index funds in the “Pensions & Investments” list of the top 50 mutual funds in U.S. defined contribution plans. InvestSense uses its proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR) to perform the analysis.

The AMVR is a simple cost/benefit analysis using the incremental costs and incremental returns of an actively managed mutual fund, as compared to a comparable benchmark, typically an index fund or market index. The AMVR is based upon the research of investment experts such as Charles D. Ellis and Burton Malkiel, as well as the fiduciary standards established by the Restatement (Third) of Trusts (Restatement) and the Prudent Investor Rule (PIR). The principles established by the Restatement and the PIR have been endorsed by the courts as the applicable standards in fiduciary law.

2Q 2018 401(k) Top 10 Mutual Funds Active Management Value Ratio™ 3.0

The Restatement stresses the importance of cost-efficiency in choosing actively managed mutual funds. Three key sections from the Restatement that every investment fiduciary should be aware of are:

  • Section 90, comment b, which states that a fiduciary has a duty to be cost-conscious.
  • Section 90, comment f, which states that a fiduciary has a duty to search for the highest return for a given level of costs and risk.
  • Section 90, comment h(2), which states that actively managed mutual funds should only be recommended when “realistically evaluated return expectations” establish that the returns from a fund will compensate an investor for the additional costs and risks generally associated with actively managed mutual funds.

As the exhibit shows, seven of the ten funds would result in a positive AMVR score, meaning the fund produced both positive incremental returns and that those returns exceeded the fund’s incremental costs. Three of the funds failed to produce positive incremental returns.

The AMVR reflects a fund’s incremental costs relative to a fund’s incremental returns. Therefore, a low AMVR score is the goal. An AMVR score between 1 and zero indicates that a fund is cost-efficient. An optimal AMVR score would be between 50 and zero. In this example 4 of the 10 fund’s AMVR scores would be considered optimal.

2Q 2018 401(k) Top 10 Mutual Funds AER-Adjusted Active Management Value Ratio™ 3.0

Given the Restatement’s mandate for the selection of cost-efficient investment options, investment fiduciaries also need to evaluate investments in terms of potential “closet index” fund status and the cost-efficiency implications of such a designation. Closet index funds are funds that hold themselves as providing the alleged benefits of active management, albeit at a much higher cost, but whose actual returns closely track, or in many cases underperform, the returns of comparable, significantly less expensive index funds.

Professor Ross Miller created a metric, the Active Expense Ratio, to expose potential closet index funds and their high costs. Professor Miller’s studies found that actively managed funds with high R-squared numbers often have effective annual expense ratios that are 400%-500% higher than the fund’s stated annual expense ratio. Higher expense ratios reduce an investor’s end-return. Each additional 1 percent in fees reduces an investor’s end-return by approximately 8.5 percent over a 10-year period and approximately 17 percent over a 20-year period.

In our, all ten of the funds had a R-squared number over 90, most were 95 or greater. As a result, the funds’ AER effective annual expense ratios rose dramatically and rendered all but one of the funds as cost-inefficient, since their AER-adjusted incremental costs far exceeded their incremental returns. Even the sole surviving cost-efficient fund, Vanguard PRIMECAP Admiral shares failed to score in the optimal range, just slipping in 0.86.

There are those in the investment industry that discount the importance of the AER and other metrics that have been created to address the increasing concern over closet indexing and its impact on investor’s returns. However, the plaintiff’s bar is successfully including such issues in their pleadings and some courts have recognized the legitimacy of the closet indexing issue. Prudent retirement plan sponsors and other investment fiduciaries would be wise to include a closet index screen as part of their due diligence process.

For more information about the AMVR and the calculation process, click here.

Conclusion
The courts have expressly recognized the value of the Restatement in interpreting fiduciary law. The Restatement stresses the importance of fiduciaries selecting cost-efficient mutual funds. To that end, the Restatement has essentially established a simple three-step screen for identifying cost-efficient investments. By using a combination of the Restatement and the Active Management Value Ratio™ 3.0, plan sponsors and other investment fiduciaries can identify prudent choices for plan participants and their beneficiaries, while reducing their personal fiduciary liability exposure as well.

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

The Active Management Value Ratio™ 3.0: Minimizing Fiduciary Liability Exposure for 401(k) Plan Sponsors

Posted on June 13, 2018 by jwatkins

Price is what you pay, value is what you receive. – Warren Buffett

A court recently dismissed an ERISA excessive fees/breach of fiduciary duty action based, at least in part, on its argument that using Vanguard mutual funds as benchmarks in ERISA cases is improper. The court’s position was based on the fact that Vanguard operates on a not-for-profit business model, while most actively managed mutual fund companies generally operate on a for-profit business model.1

Vanguard must be doing something right though, as they have more assets under management than any other mutual fund company, and growing every day. Therein lies the issue with the court’s decision-dismissing the ERISA action based on a fund’s business model, rather than the inherent value, if any, provided to a plan’s participants by an actively managed fund compared to a less expensive index fund, in this case Vanguard index funds.

ERISA’s Purpose and Standards
The purpose of ERISA is supposedly to help protect American workers’ retirement plan benefits and to help them work toward “retirement readiness.” As a result, it would seem that providing plan participants with effective investment options would be in the best interests of both plan participants and plan sponsors.

As the Supreme Court stated in their decision in Tibble v. Edison International2,  the courts often look to the Restatement (Third) of Trusts (“Restatement”) for guidance on fiduciary matters, especially involving ERISA. Three sections from the Restatement stand out with regard to the fiduciary duty of prudence.

  • Section 88, comment b, of the Restatement states that fiduciaries have a duty to be cost-conscious.
  • Section 90, aka the “Prudent Investor Rule (PIR),” comment f, states that a fiduciary has a duty to seek the highest rate of return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of expected return.
  • Section 90, comment h(2), goes even further regarding a fiduciary’s duty to be cost-efficient, stating that due to the extra costs and risks typically associated with actively managed mutual funds, such funds should not be recommended to and/or used unless their use/recommendation can be “justified by realistically evaluated return calculations” and can be “reasonably expected to compensate” for their additional costs and risks.

The evidence overwhelmingly shows that the majority of domestic equity-based, actively managed mutual funds do not and cannot meet the Restatement’s prudent investment requirements. Standard & Poor’s most recent SPIVA (Standard & Poor’s Indices Versus Active) report stated that approximately 86 percent of domestic equity-based funds failed to outperform their comparable benchmark over the period 2013-2017.3

However, analyzing an actively managed fund based on return is only half the needed due diligence process. Reading the three referenced Restatement sections together, the Restatement requires that a mutual fund should be cost-efficient, should provide a level of return commensurate with an actively managed fund’s additional costs and risks. Consistent underperformance, coupled with significantly higher fees than comparable  index funds, results in most actively managed mutual funds not being cost-efficient, which is clearly inconsistent with the Restatement’s fiduciary standards.

In the recent court decision, the court’s position was that using Vanguard index funds for benchmarking would be like comparing “apples-to-oranges” due to the difference in the fund families’ business model. Nowhere in the decisions was there any discussion of the cost-efficiency of the funds or the actual end-return benefit or value, if any, realized by the plan participants.

Determining the cost-efficiency of a fund also requires an evaluation of a fund’s stated and effective fees and expenses. In evaluating a fund’s fees and expenses, most investors and fiduciaries only focus on a fund’s annual expense ratio and any sales charges, or loads. However, studies by respected investment experts such as Burton G. Malkiel4 and Mark M.  Carhart5 have concluded that the two most reliable predictors or a fund’s success are its annual expense ratio and its trading costs. In performing the required comparisons, the Restatement and the PIR also state that fiduciaries should consider both a fund’s annual expense ratio and the fund’s trading costs.6  

Financial advisers have always argued that the prudence of their advice should be evaluated on factors other than just cost. The Restatement agrees, pointing out that in assessing the prudence of investment advice, any and all costs of the investment products recommended should be evaluated relative to the value received in exchange for such costs.7

The Active Management Value Ratio™ 3.0         
Unfortunately, the evidence from past and present ERISA actions suggests that more often than not, investment fiduciaries are recommending and pension plan fiduciaries are selecting investment options that are inefficient, both in terms of cost and/or risk management, and thus imprudent. Several years ago I created a metric that factors in all of the key criteria set out in the Restatement and the PIR. InvestSense’s proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR), is designed to allow investors, fiduciaries, and attorneys to evaluate the cost-efficiency, or the relative value, of actively managed mutual funds.

The AMVR is based in part on my experience as a securities compliance director at several broker-dealers. The AMVR is also based on the principles set out in the Restatement and the PIR , as well as the studies of investment  icons Charles D. Ellis and Burton G. 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. – Charles D. Ellis8

Past performance is not helpful in predicting future returns. The two variable that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover. – Burton G, Malkiel9                       

The beauty of the AMVR is its simplicity. In interpreting a fund’s AMVR scores, an attorney, fiduciary or investor only has to answer two questions:

  1. Does the actively managed mutual fund produce a positive incremental return?
  2. If so, does the fund’s incremental return exceed it incremental costs?

If the answer to either of these questions is “no,” then the fund does not qualify as cost-efficient under the Restatement’s guidelines.

Our example compares a popular actively managed, large cap domestic fund, American Funds’ Growth of America Fund, R-6 shares (RGAGX), with a comparable large cap growth index fund, the Vanguard Growth Index Fund Admiral shares(VIGAX). Two key facts quickly indicate that RGAGX is not cost-efficient, and thus an imprudent investment choice:

  • RGAGX outperforms VIGAX on both a nominal and a risk-adjusted return basis, earning a very respectable AMVR score of .50. An AMVR score greater than zero and less than 1.00 is the goal, as it shows that the fund’s incremental return was positive and exceeded the fund’s incremental costs. A score greater than zero and 50 or less is very good
  • However, RGAGX has a very high R-squared rating of approximately 95, definitely in an area considered to constitute “closet index” fund status. As a result, RGAGX has a high AER score, resulting in the fund’s incremental costs significantly exceeding the fund’s incremental return, and thus not cost-efficient.
  • RGAGX also fails the cost-efficiency standards, both in terms of its nominal and risk-adjusted numbers. RGAGX’s incremental return only accounts for 7 percent of RGAGX’s risk-adjusted return At the same time, RGAGX’s nominal incremental cost constitutes 81 percent of RGAGX’s total expense, while its AER-adjusted incremental cost constitutes 98 percent of the fund’s total expense. Funds whose incremental costs are greater than their incremental return are not cost-efficient.

In our forensic fiduciary analyses, we then analyze the surviving cost-efficient funds based on over-all efficiency, both in terms of cost control and risk management, and historical consistency of performance.

For additional information about the AMVR and the calculation process itself, visit our web site, “The Prudent Investment Fiduciary Rules (iainsight.wordpress.com). To view the latest AMVR forensic analysis of “Pensions & Investments,” top ten non-index funds used by 401(k) plans visit our SlideShare presentation.

Closet Indexing and the AMVR         
Those statistics do not even tell the whole story. One of the most currently discussed investment issues internationally is the impact of “closet index” funds. Closet index funds are mutual funds that hold themselves out as providing active management and charge higher fees than index funds based on such claims. However, the truth is that actively managed mutual funds often closely track the performance of a comparable index fund or market index, often even underperforming the index fund due to their high costs.

Higher fees for less return than a comparable index fund, essentially a net loss for an investor. Definitely not a scenario that furthers ERISA’s purposes. And yet, the issue is rarely addressed by courts involved in ERISA excessive fees/breach of fiduciary duty actions, even though the evidence clearly shows that closet indexing is definitely a problem in the United States, one which unfairly reduces the end-returns of investors and pension plan participants.

Closet index funds are generally identified through the use of a fund’s R-squared number. Morningstar defines R-squared as “the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 100,… It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns.”10

The AMVR factors in Ross Miller’s Active Expense Ratio (AER) metric.11  The AER uses a fund’s R-squared number to calculate the active component of an actively managed mutual fund and the resulting effective annual expense ratio an investor is paying on an actively managed mutual funds. The AER calculation allows pension plan fiduciaries and plan participants to evaluate the impact of the actively managed funds’ extra costs on the funds’ cost-efficiency.

In our example, the impact of RGAGX’s high R-squared number/closet index factor, 95, can be seen in the fact that RGAGX’s AER number rose significantly and the percentage of the incremental fee as a percentage of the fund’s overall fee rose to approximately 98 percent of the fund’s overall fee.

For 401(k) fiduciaries and plan participants, the key questions involving the selection of closet index funds for pension plans include:

  • Does the selection of a closet index fund breach an ERISA fiduciary’s duties of loyalty and prudence, given the combination of the fund’s higher annual expense ratio with returns more attributable to the market than the fund’s management?
  • Since the performance of closet index funds are the same (or in most cases slightly less due to the fund’s higher fees and costs) as comparable index funds, is it prudent for an ERISA fiduciary to pay the closet index fund’s higher fees and costs?

Conclusion

“Wasting beneficiaries’ money is imprudent.”–Section 7 of the UPIA

Under basic fiduciary law, a key concept is the “best interests” of a pension plans and its participants. I believe that the evidence discussed herein, along with the findings of most forensic analyses using the AMVR, create some pivotal questions for pension plan sponsors and other plan fiduciaries, as well as the courts, going forward, namely

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

The issue with actively managed mutual funds is that the evidence clearly shows that historically, the majority of actively managed funds are not efficient, either in terms of performance or costs, as a large majority of actively managed mutual funds consistently underperform comparable, less expensive index mutual funds, thus failing to meet the fiduciary standards established by the Restatement.

Plan sponsors and other investment fiduciaries would be well-served to properly evaluate their plans in order to ensure they have a truly ERISA compliant pension plan, thereby  minimizing their risk of personal liability exposure.

Notes
1. Brotherson et al. v. Putnam Investments, Inc., available online at          http://www.investmentnews.com/assets/docs/Cl10985646
2. Tibble v. Edison International, 135 S. Ct. 1823, 1828 (2015)
3. https://us.spindices.com/spiva/#/reports   
4. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
5. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
6. Restatement (Third) Trusts, Section 90, comments b, c, f, g, h(2) and m
7. Restatement (Third) Trusts, Section 90, comments b, c, f, g, h(2) and m
8. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,”6th ed. (New York, NY: McGraw/Hill, 2018), 10
9. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
10. http://www.morningstar.com/InvGlossary/r_squared_definition_what_is.aspx
11. Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926

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

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

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, 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 , , , , , , , , , , , , , , , , , , , , , | 8 Comments

Judge Judy and the SEC’s Best Interest Proposal

Posted on May 25, 2018 by jwatkins

The SEC recently announced its “kinda fiduciary”proposal, allegedly to provide investors with protection against abusive marketing strategies used by the investment industry. Interestingly, the SEC choose not to use the term “fiduciary” in announcing its proposal, instead referring to new “Best Interest” (BI) proposal. The issue did not go unnoticed.

While various post and articles have been written regarding the BI proposal, two articles written by leading ERISA attorney Fred Reish provided very informative and insightful analyses comparing the BI proposal to the terms of the DOL’s recent fiduciary rule and its Best Interest Contract Exemption (BICE). I would strongly recommend that anyone in either the investment or ERISA industries take the time to read Mr. Reish’s articles.

One of the most common criticisms of the SEC’s BI proposal is the noticeable lack of any definition of “best interests.” Mr. Reish addressed the issue by referring to the DOL rule’s definition of “best interests.” Under the DOL rule, “best interests” was defined as follows:

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party. (emphasis added)

At some point, the SEC is going to have to address the issue of the definition of “best interest” under their “fiduciary” proposal. Commons sense would suggest that the easiest and most effective option would be to adopt the DOL rule’s definition of “best interests.” If, as expected, the DOL chooses to adopt the SEC’s eventual “fiduciary rule, this would obviously make the transition easier for the DOL, plan sponsors and plan participants..

The DOL’s definition of “best interest” would also further the alleged purpose of the SEC’s BI proposal – protecting investors. I’ve highlighted two sections of the DOL’s definition to illustrate how their inclusion in the DOL’s rule provides the fiduciary protection that investors need.

The United States Supreme Court recently stated that in matters involving fiduciary law, the Court often looks to the Restatement of Trusts (Restatement) for guidance. The Restatement (Third) of Trusts emphasizes two basic fiduciary duties – the duty to be cost-conscious and cost-efficient (Section 88), and the duty to be prudent (Section 90, aka “The Prudent Investor Rule”). The first part of the DOL rule is a direct quote from Section 90’s definition of the fiduciary duty of prudence.

Section 78 of the Restatement discusses a fiduciary’s duty of loyalty. Once again, the DOL rule’s language essentially tracks the Restatement’s language.

If the SEC is sincere in adopting a fiduciary standard, then the similarity in langauge between the Restatement and the DOL’s rule makes adoption of the DOL’s rule definition of “best interests” the simple and obvious solution for defining “best interests” under the SEC’s BI proposal.

I’m guessing that that is not going to happen for two reasons. I am records as stating that the SEC does not actually want to adopt, in fact cannot adopt, a true, meaningful fiduciary standard for two basic reasons. First, many SEC commissioners look to Wall Street for employment after their SEC terms end. A true fiduciary standard is not something the investment industry wants.

Why? Because Wall Street and the investment industry know that their current business model cannot comply with a true fiduciary standard, especially once based on the Restatement’s stringent standards.

For example, the investment industry relies heavily on the sale of actively managed mutual funds to individual investors and pension plans/participants. The two most noticeable aspects of actively managed mutual funds is their consistent underperformance and excessive fees when compared to comparable index funds.

Comment h(2) addresses the cost-efficiency issues involved with actively managed mutual funds, noting that such funds often involve higher costs and risk than comparable index funds. As a result, the Restatement cautions that actively managed funds should not be recommended or used in investment accounts unless  “realistically evaluated return expectations” will compensate an investor for the actively managed fund’s additional costs and risks.

Simply put, this is a hurdle that most actively managed funds simply cannot meet. The most recent S&P  Indices Versus Active report stated that 86.72 percent of actively managed domestic equity funds failed to outperform their appropriate benchmark. My own experience in performing forensic analyses on actively managed mutual funds using my metric, the Active Management Value Ratio™ (AMVR), has consistently shown that actively managed funds are not cost-efficient, in many cases even before their front-end load- adjusted and/or risk-adjusted returns are factored in.

Bottom line, the investment industry cannot effectively do business under their current business models if a meaningful fiduciary standard is imposed on them. that’s exactly why the industry fought so hard against the DOL’s proposed fiduciary rule and will fight against the SEC’s BI proposal if the SEC attempts to adopt similar fiduciary guidelines.

So I would suggest that they key to the SEC’s whole BI proposal is whether they balk in any way at adopting the DOL rule’s “best interest” definition. It’s there for the taking and perfectly describes the concept of “best interests” for investors. If the SEC balks in any way in adopting the DOL’s definition, then everyone will immediately see the BI proposal for what it is, a ruse and an accommodation to Wall Street and the investment industry. In the words of the great philosopher Judge Judy, “don’t pee on my leg and tell me it’s raining.”

Happy Memorial Day!

 

 

Posted in 401k, 401k investments, 403b, 404c, 404c compliance, BICE, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, Impartial Conduct Standards, investment advisers, investments, IRA, IRAs, pension plans, prudence, retirement plans, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

May It Please the Court: Justice Denied As Courts Miss the Forest for the Trees in ERISA Actions

Posted on May 6, 2018 by jwatkins

Price is what you pay, value is what you receive. – Warren Buffett

As any trial attorney will tell you, there are times when you wonder if a judge just does not understand a case or if you are just getting a good ‘ol serving of “home cookin’.” Reading some recent decisions in which a court has dismissed an ERISA action alleging excessive fees and/or a breach of one’s fiduciary’s duties, I can’t help but just shake my head, as the dismissals have supposedly been based at least in part on the business model of the plan’s respective mutual funds.

The courts in the cases have argued that using Vanguard mutual funds as benchmarks in ERISA cases is improper because Vanguard operates on a not-for-profit business model, while most actively managed mutual fund companies generally operate on a for-profit business model. Vanguard must be doing something right though, as they have more assets under management than any other mutual fund company, and growing every day. And therein lies the issue with the decisions to dismiss the ERISA actions based on a fund’s business model.

The purpose of ERISA is supposedly to help protect American workers’ retirement plan benefits and to help them work toward “retirement readiness.” As a result, it would seem that providing plan participants with effective investment options would be in the best interests of both plan participants and plan sponsors.

As the Supreme Court stated in their decision in Tibble v. Edison International,  the courts often look to the Restatement (Third) of Trusts (“Restatement”) for guidance on fiduciary matters, especially involving ERISA. Section 88 of the Restatement says that fiduciaries have a duty to be cost-conscious. Section 90, comment h(2) goes even further on a fiduciary’s duty to be cost-efficient, stating that due to the extra costs and risks typically associated with actively managed mutual funds, such funds should not be used for or recommended to clients unless their use/recommendation can be “justified by realistically evaluated return calculations” and can be “reasonably expected to compensate” for their additional costs and risks.

Simply put, the evidence overwhelmingly shows that the majority of domestic equity-based actively managed mutual funds cannot and do not meet the Restatement’s prudent investment requirements. Standard & Poor’s most recent SPIVA (Standard & Poor’s Indices Versus Active) report stated that approximately 90 percent of domestic equity-based funds failed to outperform their comparable benchmark over the past year.

In the most recent court decisions, the courts claimed that using Vanguard index funds for benchmarking would be like comparing “apples-to-oranges” due to the difference in the fund families’ business model. Nowhere in the decisions was there any mention as to the relative performance between the funds, the actual end-return benefit or value, if any, realized by the plan participants.

Since I enjoy doing forensic analyses of investments and pension plans, I figured I would perform such an analysis. Each year I perform a forensic analysis of the top ten mutual funds being used in defined contribution plans, as reported by “Pensions & Investments (“P&I”).” Past analyses are available online at the SlideShare site.

Using the top ten funds from P&I’s most recent report, I analyzed the five-year annualized returns (for the period ending on March 31, 2018) on the ten funds on both a nominal and risk-adjusted basis. I used four Vanguard index funds for benchmarking – VFIAX (large cap blend), VIGAX (large cap growth), VVIAX (large cap value), and VMMAX (midcap value). Total costs are based on a fund’s annual expense ratio and estimated trading costs, using John Bogle’s trading costs metric. My findings on the funds’ nominal and risk-adjusted incremental returns relative to each fund’s incremental total costs are as follows:

  • Fidelity Contrafund (FCNKX) – 91% of the fund’s fees/costs produced just 5.9% of the fund’s nominal return and 6.8% of the fund’s risk-adjusted return.
  • American Funds’ Growth Fund of America (RGAGX) – 82% of the fund’s fees/costs produced just 6.1% of the fund’s nominal return and 7.0% of the fund’s risk-adjusted return.
  • American Funds’ Washington Mutual (RWMGX)- 80% of the fund’s fees/costs produced just 4.2% of the fund’s nominal return and 5.1% of the fund’s risk-adjusted return.
  • American Funds’ Fundamental Investors (RFNGX)  – 87% of the fund’s fees/costs produced just 4.0% of the fund’s nominal return and 3.9% of the fund’s risk-adjusted return.
  • Dodge & Cox Stock (DODGX) – 88% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return and 6.9% of the fund’s risk-adjusted return.
  • Vanguard PRIMECAP (VMMAX)- 81% of the fund’s fees/costs produced just 15.2% of the fund’s nominal return and 16.8% of the fund’s risk-adjusted return.
  • Fidelity Growth Company (FGCKX) – 92% of the fund’s fees/costs produced just 25.0% of the fund’s nominal return and 25.0% of the fund’s risk-adjusted return.
  • T. Rowe Price Blue Chip Growth (RRBGX) – 95% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return. The fund failed to provide any positive incremental risk-adjusted return.
  • T. Rowe Price Blue Chip Growth (RRBGX) – 95% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return. The fund failed to provide any positive incremental risk-adjusted return.
  • MFS Value (MEIKX) – 88% of the fund’s fees/costs failed to provide any positive incremental nominal or risk-adjusted return.
  • Fidelity Low Price Stock (FLPKX) – 90% of the fund’s fee failed to provide any positive incremental nominal or risk-adjusted return.

With a few exceptions, those performances obviously do not come close to meeting the Restatement’s prudent investor standards. As is noted in the notes in Section 88 of the Restatement, “wasting beneficiaries money is never prudent.”

However, those statistics do not even tell the whole story. One of the most currently discussed investment issues internationally is the impact of “closet index” funds. Closet index funds are mutual funds that hold themselves out as providing active management and charge higher fees than index funds based on such claims. However, the truth is that such funds often closely track the performance of a comparable index fund or market index, often even underperforming the index fund. Higher fees for less return than a comparable index fund, essentially a net loss for an investor. Not sure how that situation furthers ERISA’s purposes.

I performed the same forensic analysis on the same ten funds using Ross Miller’s Active Expense Ratio (“AER”). The AER  calculates an actively managed fund’s effective annual expense ratio based on its R-squared number. R-squared is a metric that measures one fund’s correlation of returns with another fund or an actual market index.

In each case a fund’s incremental return numbers remained the same, but the percentage of the fee producing the returns all rose to 98% or 99%. The average AER number for the ten funds was 4.95 percent , about 9 times higher than the  funds’ stated average annual expense ratio of 0.549 percent. Again, not sure that the results of the actively managed funds’ closet index analysis are consistent with ERISA’s purposes or further the goal of “retirement readiness” for plan participants.

Keep in mind, these are the top ten funds currently used in defined contribution plans. The findings should be alarming enough. The fact that in some cases a fund’s entire incremental fee failed to produce any positive incremental return is a clear breach of the plan sponsor’s fiduciary duty. And yet the courts in question focused not on the miserable performance of such funds and the impact of same on plan participants’ retirement accounts, but rather on the available funds’ choice of business model.

Conclusion

Brokers and broker-dealers are celebrating the 5th Circuit’s adverse ruling against the DOL’s fiduciary rule, assuming that they cannot be held to a fiduciary standard in dealing with their ERISA customers.  I would suggest that such brokers and broker-dealers might want to review my previous post discussing how the regulatory and legal system have already been addressing the fiduciary issue. I would also suggest that broker-dealers and brokers review the applicable fiduciary state law in states that have adopted their own fiduciary standards or who are classified as quasi-fiduciary states, where state courts have the power to impose a fiduciary standard on brokers on a case-by-case basis, even in connection with non-discretionary accounts.

The DOL fiduciary rule may be dead and only time will tell whether the SEC adopts a meaningful universal fiduciary standard or merely a watered-down version of FINRA’s current suitability standard. Interestingly enough, FINRA came out in FINRA Regulatory Notice 12-25 and stated that their suitability standard and the “best interest” standard are “inextricably intertwined,” seemingly opening the door to a “fiduciary standard” interpretation, although FINRA did not expressly use the “f” word. Probably more double speak.

At the very least, the debate over the DOL rule has hopefully at least better educated investors with regard to the fiduciary conflicts-of-interest issue and raised their consciousness regarding the need to be more proactive in protecting their financial interests and security. Prudent investment advisers will embrace the new fiduciary movement and capitalize on the marketing opportunity it presents for them to demonstrate their value proposition to both existing and prospective clients. Lord knows, as my forensic analyses show, too many plan participants are currently receiving little or no value for their money.

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

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

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, elder law, elderly investment fraud, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, investment advisers, investments, IRA, IRAs, pension plans, prudence, retirement plans, RIA, RIA Compliance, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , | Leave a comment

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

Posted on March 13, 2018 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

EXHIBIT A

YrR – Annualized Return
ER – Expense Ratio
TO – Turnover

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

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

Posted on January 17, 2018 by jwatkins

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

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

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

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

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

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

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


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

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


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

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

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

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

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

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

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

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

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

2017 Year-End Top 10 DC Funds AMVR Analysis

Posted on January 5, 2018 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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