In my last post, I published the “cheat sheets” for six of the most commonly used non-index-based funds in U.S. defined contribution plans. However, those funds did not include any target date funds (TDFs).
TDFs are diversified asset allocation funds which supposedly provide a simple way for investors to work toward “retirement readiness” and “financial well-being.” However, questions have started to arrive as to the prudence of TDFs in terms of both safety and cost-efficiency. As a result. TDFs have become the targets themselves of 401(k) and 403(b) litigation.
Two of the largest litigation targets have been Fidelity’s Freedom TDFs and TIAA-CREF’s Lifecycle TDFs. One of the primary issues in litigation involving these two groups of TDFs has been the fact that both offer both active and passive versions of their TDFs.
In both cases, the active versions of the TDFs charge higher fees. Most 401(k) and 403(b) plans have chosen the active versions of the TDFs, despite their consistent underperformance over time relative to the less expensive passive, or index, versions of the funds.
Several courts have dismissed 401(k) and 403(b) cases citing the alleged failure of the plan participants to properly plead their cases. Under the federal rules of civil procedure, the plan participants are required to provide sufficient facts to show that it is plausible to believe that the plan’s sponsor failed to properly perform their fiduciary duties of loyalty and/or prudence.
Some courts have accepted evidence of the disparity between a fund’s costs and returns as providing sufficient evidence of the plausibility that a plan sponsors failed to properly perform their fiduciary duties. One such case is the Leber v. Citigroup 401(k) action1, where highly respected Judge Sidney Stein denied Citigroup’s motion to dismiss the case, citing the fact that the plan participants had shown that in some cases the expense ratios of the funds in question were 200 percent of more higher than the expense ratios of comparable Vanguard funds.
Judge Stein’s recognition of both the impact of a disparity in expense ratios and the legitimacy of Vanguard funds as comparators in 401(k) and 403(b) cases should not go unnoticed. Nevertheless, some courts continue to ignore and/or reject similar evidence as establishing the plausibility of a fiduciary breach, as required in 401(k) and 403(b) cases.
In my practice, I also calculate a “plausibility factor” based upon my Active Management Value Ratio (AMVR) analyses. In the case of the two charts shown above, the plausibility should be resolved for the five-year period by the fact that with the exception of two cases,none of the TDFs even managed to provide a positive incremental return at all. In the two cases where the funds did produce a positive incremental return, the funds’ incremental costs exceeded such returns, making them cost-inefficient.
The plausibility analysis for the ten-year AMVR analysis not only shows the significant percentage disparity in incremental costs and incremental returns, but also how important it is for a fiduciary to factor in risk in order to obtain a meaningful “apples to apples” assessment and to avoid unnecessary exposure to fiduciary liability.
Interestingly, while pension plans and the financial services that argue for “apples to apples” comparisons, they generally dismiss risk-adjusted analyses. This plausibility chart may help explain why.
Going Forward I am on record as saying that plan participants should never lose a properly vetted 401(k)/403(b) case. My position is based on the ease with which plan participants and their attorneys can establish both the plausibility and the legitimacy of the damages in their case through the use of the AMVR metric and plausibility analysis. Both analyses require nothing more than simple math and provide compelling evidence of any fiduciary breach. As John Adams said, “facts are stubborn things.”
Notes 1. Leber v. Citigroup 401(k) Plan Inv. Committee, 2014 WL 4851816.
James W. Watkins, III, J.D., CFP Board EmeritusTM, AWMA
Given the recent performance of the markets, it should come as no surprise that the 5 and 10-Year AMVR analyses of the six most popular non-index mutual funds in U.S. defined contribution plans remain relatively unchanged.
Interesting to note that for both the 5 and 10-year period, only Vanguard PRIMECAP Admiral shares managed to qualify for an AMVR ranking.
Also interesting to note the importance of factoring in a fund’s risk-adjusted returns. On the 5-year AMVR analyses, factoring in risk-adjusted returns turned AF’s Washington Mutual Fund’s incremental return from (0.90) on nominal returns, to a positive 0.13. Admittedly, a small positive number, but still a significant change.
On the 10-year AMVR analyses slide, factoring in the fund’s risk-adjusted returns turned their incremental return from (0.57) (nominal) to 0.57 (risk-adjusted.) Likewise for Fidelity Contafund, where an incremental return of (0.79) (nominal) turned into a small, yet positive, 0.09.
Overall, the song remains the same, with the majority of actively managed funds being unable to overcome the combination of the weight of higher fees and cost and high r-squared/correlation of returns number to beat the index of comparable index funds
And so, we continue to see 401(k) actions alleging a breach of fiduciary duties by plan sponsors. Of note, we are seeing an increasing number of cases focusing on target date funds (TDFs). I expect to see more actions involving TDFs, as the AMVR provides compelling evidence of the imprudence of the active versions of such funds. I will post an updated analysis of the active and index versions of both the Fidelity Freedom and TIAA-CREF Lifestyle TDFs next week
I have often noted SCOTUS’ recognition that an ERISA fiduciary’s duties are “derived from the common law of trusts. In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts.”1
This statement from SCOTUS should not come as a surprise. Courts have often noted that ERISA is essentially a codification of the common law of trusts, as reflected in the Restatement of Trusts (Restatement). This similarity is especially noticeable in the fact that two consistent themes run throughout both of them-the importance of cost-consciousness and risk management.
As an ERISA attorney, I created the Active Management Value (AMVR) metric as a means of focusing on these topics in the context of fiduciary liability, specifically liability based on cost-inefficiency and ineffective risk management.
The basic AMVR is based primarily on the research of Charles D. Ellis and Nobel laureate Dr, William F. Sharpe. Dr. Sharpe has offered the following advice for analyzing the prudence of mutual funds:
Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.2
Noted wealth management expert, Ellis, goes further, stating that
So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!3
The financial services industry and 401(k)/403(b) plan advisers like to avoid the issues of fiduciary duties, transparency, and cost-inefficiency by avoiding comparisons of fund performance and only discussing returns in terms of nominal, or publicly stated, returns. Unfortunately, nominal returns are often misleading when fiduciary duties and potential fiduciary liability is involved.
AMVR FAQs As the basic AMVR has gained increased recognition and use by investment fiduciaries and attorneys, there has also been increased recognition of the potential for the power of the advanced version of the AMVR, aka AMVR+. The basic AMVR is simply the cost/benefit analysis many of us used in our Econ 101 class, with the inputs being incremental costs and incremental returns.
In analyzing an AMVR analysis, the user only needs to answer two simple questions:
(1) Did the actively managed fund provide a positive incremental return? (2) If so, did actively managed fund’s positive incremental return exceed the fund’s incremental costs.
If the answer to either of these questions is “no,” then, under the Restatement’s standards, the actively managed fund is imprudent relative to the benchmark index fund.
Here, the active fund’s incremental costs (72 basis points) exceed the fund’s incremental returns (5 basis points). “Basis points” is a term used in the financial services industry. I often tell people to just monetize the results by thinking in terms of dollars. Would you give someone $72 in exchange for $5. The prosecution rests.
Sadly, this scenario is common in 401(k)/403(b) plans. As a result, the number of ERISA actions against 401(k)/403(b) plans continues to increase.
The AMVR could easily help 401(k)/403(b) plans avoid such unnecessary liability exposure. Most AMVR analyses can be accomplished in 1-2 minutes and require no more than what one judge described as “third grade math…but very persuasive third grade math,” as he denied a plan’s motion to prevent the use of the AMVR in a 401(k) action.
Advanced AMVR Analysis A well-known saying in the investment industry is that “amateurs focus on returns; professionals focus on risk management.” Search “investment risk management Charles D. Ellis” and you will find his familiar statement that the secret of successful investing is the informed management of investment risk. Perform the same search using the names of investment icons Benjamin Graham and Paul Tudor Jones and you will find similar statements.
Plan sponsors and other investment fiduciaries are gradually recognizing the power of the AMVR as a risk management tool. The advanced version of the AMVR, AMVR+, addresses three types of risk:
1. The risk of cost-inefficiency, 2. The risk of underperformance, and 3. The risk of the investment risk, aka volatility.
The Risk of Cost-Inefficiency The basic premise of cost-inefficiency is simple to express–costs exceeding benefits/returns. In connection with investing and the AMVR, it is incremental costs exceeding incremental benefits aka returns. An investment in a cost-efficient investment means an investor would actually be losing money. The fact that costs, like returns, compound over time only exacerbates the investment risk and resulting damage.
While many people continue to debate the relative merits of active management versus passive management, I maintain that issue is, and always has been, a meaningless debate. The more meaningful question is cost-efficiency versus cost-inefficiency.
A cost-inefficient investment can never be a prudent investment choice, especially for an investment fiduciary. Even the Restatement acknowledges this fact.
The cost-inefficiency of many actively managed funds may be even worse than it appears at first glance. Ross Miller’s Active Expense Ratio suggests that the effective expense ratio of many actively managed funds is often understated by as much as 400-500 percent. Miller explained the importance of the Active Expense Ratio and AW as follows:
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.4
The Risk of Underperformance Again, a simple concept. An actively managed fund that fails to provide a positive incremental return when compared to a comparable index fund represents an opportunity cost equal to the incremental return that could have been realized by investing in the better performing index fund.
Studies have consistently shown that the overwhelming majority of actively managed funds underperform comparable index funds.5 Given the higher costs typically associated with active management, including higher management fees and trading costs, these findings should come as no surprise, especially given the high correlation of returns between most U.S. domestic equity funds and their index counterparts.
The high correlation of return, often 95 and above, raises the issue of potential “closet indexing.” Closet indexing refers to the practice of actively managed funds marketing the benefits of the active management they allegedly provide, only to provide similar, in many cases lower returns. than a comparable index fund
Correlations of 95 and above raise genuine issues of whether active management was provided at all, and the issue of exactly how much active management was provided. Ross Miller’s Active Expense Ratio metric calculates the Active Weight (AW), or the percentage of active management provided by a fund. AW can be calculated simply through the use of an actively managed fund’s expense ratio and its r-squared, or correlation of returns, number.
With so many active funds having a correlation of 95 and above to comparable index funds, it is interesting to note the estimated AW of such funds. Miller found that there is not a one-to-one correlation between r-squared to the percentage of active management provided. For instance, Miller found that active funds with a correlation number of 98 only provide an estimated 12.50 percent in active management.
Miller’s studies clearly demonstrate the value of factoring in correlations of return between actively managed funds and comparable index funds. This is why we use Miller’s Active Expense Ratio in calculating correlation-adjusted costs in order to provide a more meaningful cost-efficiency analysis in our AMVR+ analyses.
The Risk of Investment Risk/Volatility Studies have consistently shown that investment returns are influenced by the level of investment risk assumed, the so-called risk-return equation.
Section 90, comment h(2). of the Restatement (Third) of Trusts is a fundamental principle of fiduciary law and prudent investing. Section 90(h)(2) states that the use of actively managed strategies is imprudent unless it can be reasonably predicted that the active strategy will provide a commensurate return for the additional costs and risks typically associated with active investing.
As mentioned previously, most actively managed funds simply cannot meet this requirement, due largely to the burden of higher management fees/expenses and trading costs. This is the reason InvestSense factors in a fund’s risk-adjusted return in our AMVR+ cost-efficiency analyses. While many advocates of active management dislike the use of risk-adjusted returns, the fact is that factoring in risk often improves the cost-efficiency numbers for actively managed funds since it is a factor that they can actually control.
Going Forward The evidence clearly establishes the potential benefits of the AMVR and AMVR for investment fiduciaries, attorneys, and investors. Investment fiduciaries can avoid unnecessary and unwanted fiduciary liability exposure. Attorneys and easily establish the merits of their case and comply with applicable pleading standards. Investors can analyze the prudence of their investment and hopefully better protect their financial security.
Notes 1. Tibble v. Edison International, 135 S. Ct 1823 (2015) 2. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm. 3, Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c. 4. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4. 5. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010); Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8e; Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997); Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016.
Just when you thought it was safe to go back in the water, the Sixth Circuit issues its decision in Smith v. CommonSpirit Health (CommonSpirit).1 The Sixth Circuit dismissed the plan participant’s action, largely upon the familiar argument that market indices and/or comparable index funds are not “meaningful benchmarks” for the purposes of 401(k) litigation.
That issue was supposedly resolved by the combination of the First Circuit’s Brotherston decision2 and SCOTUS’ subsequent denial of Putnam’s application of certiorari for review.3 When SCOTUS denies an application for certiorari, it is generally understood that the Court approves of both the lower court’s decision and the rationale behind the decision.
In Brotherston, Judge Kayatta offered a well-reasoned decision with regard to why market indices and/or comparable index funds are appropriate for benchmarking purposes in 401(k) litigation.
The recovery from a trustee for imprudent or otherwise improper investments is ordinarily ‘the difference between (1) the value of those investments and their income and other product at the time of surcharge and (2) the amount of funds expended in making the improper investments, increased (or decreased) by a projected amount of total return (or negative total return) that would have accrued to the trust and its beneficiaries if the funds had been properly invested.’ Id. § 100 cmt. b(1). Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes ‘return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).’4
ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for ‘any losses to the plan resulting from each such breach.’ 29 U.S.C. § 1109(a). Certainly, this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent ‘to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.’ And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts.
In this instance, the trust law that we have described provides an answer that both requires no stretch of ERISA’s text and accords with common sense.6
So, to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes);…7
The Sixth Circuit offered no explanation in its CommonSpirit decision as to why the Brotherston decision, and SCOTUS’ subsequent refusal to review said decision was not applicable. The court simply ignored the First Circuit’s decision regarding the fiduciary prudence and benchmarking argumwent. While Circuit Courts of Appeal are not obligated to follow the decisions of other circuits, one could argue that the First Circuit’s reliance on the Restatement (Third) of Trusts (Restatement), and SCOTUS’ refusal to hear Putnam’s appeal, are compelling reasons to follow the rationale expressed in Brotherston.
As a fiduciary risk management consultant that offers fiduciary oversight services to 401(k) a nd 403(b) plans, the CommonSpirit decision concerns me for several reasons. First, based on the Brotherston decision and SCOTUS’ denial of certiorari, I believe that SCOTUS will ultimately expressly adopt the Restatement’s position and rule that market indices and comparable index funds are appropriate for benchmarking purposes in 401(k) litigation.
Second, if SCOTUS does adopt this position, then plan sponsors will find themselves in the same position they have found themselves in after SCOTUS’ decision in Hughes v. Northwestern University8 – utterly defenseless to breach of fiduciary prudence claims. The fact that a plan sponsor relies on the Sixth Circuit’s decision, or any other court decision subsequently vacated, will not serve as a defense to fiduciary breach claims. Courts face no legal liability for decisions subsequently vacated.
Some plan sponsors have asked me whether they have legal recourse against plan providers/advisers that led them to believe they could rely on a court’s decision. While SCOTUS has ruled that plans may sue plan providers/advisers based on common law principles such as negligence, fraud, and breach of contract, nothing is guaranteed.9
We have seen several instances where plan providers/advisers have voluntarily agreed to cover half of any damages awarded as a result of 401(k) litigation. Whether that trend will continue is uncertain.
Going Forward My primary criticism of decisions such as the CommonSpirit decision is that they create a false of security, resulting in plan sponsors failing to seek proper legal advice to protect themselves and the plan’s participants. This is especially true in situations such as CommonSpirit, when the applicable legal standard has arguably been previously established and endorsed by SCOTUS.
That said, plan sponsors have a duty to understand and fulfill their fiduciary duties to the plan and the plan’s participants. If a plan sponsor chooses to rely on conflicted plan providers and advisers, rather than experienced ERISA attorneys, then the plan sponsor has to accept the consequences for such decisions.
Unfortunately, it appears that the CommonSpirit decision will not be appealed to SCOTUS. As a result, more 401(k) plans and plan sponsors will needlessly be exposed to unlimited personal liability unless and until SCOTUS does rule that market indices and comparable index funds are appropriate benchmarks in 401(k) litigation under the Restatement.
Notes 1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022). 2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 1stt Cir. 2018) 3. Putnam Investments, LLC v. Brotherston – SCOTUSblog 4. Brotherston, 31. 5. Brotherston, 31. 6. Brotherston, 32. 7. Brotherston, 34. 8. Hughes v. Northwestern University, 142 S.Ct. 737 (2022). 9. Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 90 103 S.Ct. 2890 (1983).
I have written several posts on this blog critiquing the Sixth Circuit’s decision in Smith v. CommonSpirit Health (CommonSpirit). The decision, particularly the court’s “apples and oranges” argument is inconsistent with the both the First Circuit’s decision in Brotherston v. Putnam Investments, LLC, and the Restatement (Third) of Trust’s explicit approval of index funds for benchmarking purposes by fiduciaries. The fact that SCOTUS denied Putnam’s petition for certiorari clearly indicates that the Court agrees with both the First Circuit’s decision and the rationale behind the decision.
In retrospect, I believe the CommonSpirit decision may have done plan participants and ERISA plaintiff’s attorney a favor by opening “Pandora’s Box” as to a common issue with some 401(k)/403(b) plans and plan advisers/providers, that question being
Are plan sponsors and ERISA plaintiff’s attorneys overlooking a potentially significant breach of a plan sponsor’s fiduciary duties of loyalty and prudence?
ERISA case law is very clear that a plan sponsor’s fiduciary duties extend to the selection and monitoring of a plan’s plan advisers and providers.
[W]here the trustees lack the requisite knowledge, experience and expertise to make the necessary decisions with respect to investments, their fiduciary obligations require them to hire independent professional advisors….1
Failure to utilize due care in selecting and monitoring a fund’s service providers constitutes a breach of a trustees’ fiduciary duty. At the very least, trustees have an obligation to (i) determine the needs of a fund’s participants, (ii) review the services provided and fees charged by a number of different providers and (iii) select the provider whose service level, quality and fees best matches the fund’s needs and financial situation. Trustees also have an ongoing obligation to monitor the fees charged and services provided by service providers with whom a fund has an agreement, to ensure that renewal of such agreements is in the best interest of the fund.2
In the recent CommonSpirit decision, it appears that that very issue was never raised by plaintiff’s attorney. The issue may have been raised implicitly or collaterally in addressing other alleged fiduciary breaches. To be honest, I do not even remember a case where that specific issue was raised as a separate fiduciary breach by a plan sponsor.
I believe the timing is right to address the following question: Does a plan sponsor breach their fiduciary duties of loyalty and prudence if they select and/or maintain a plan adviser and/or provider who is affiliated with an investment company that offers various investment products for a 401(k)/403(b) plan, but the investment company does not make available all of its investment products to such plans, effectively forcing them to settle for less prudent investment products in order to financially benefit the investment company and/or the plan adviser/provider
In CommonSpirit, the primary issue involved the plan’s choice of the active suite of Fidelity Freedom TDF funds. A forensic analysis comparing the active suite of the Fidelity Freedom 2035 TDF to the comparable index version of the same fund is shown below. InvestSense’s proprietary metric, the Active Management Value Ratio (AMVR), was used to perform the forensic analysis.
The combination of underperformance relative to the index version and the incremental cost, with no commensurate return at all, would indicate that the active suite version is cost-inefficient relative to the index version of the fund and, thus, imprudent.
And yet, the plan sponsor chose and continued to offer the active suite of Fidelity Freedom TDFs within the plan. Based on the discussion within the decision, Fidelity may not make the index version of the Fidelity Freedom TDFs available to 401(k) or 403(b) plans.
A similar AMVR analysis of several of the other active suite Fidelity Freedom TDFs suggests that the funds analyzed are also imprudent based on cost-inefficiency.
The results shown on the two slides raise obvious questions with regard to possible fiduciary breaches by the CommonSpirit plan sponsor and other plan fiduciaries. Even if Fidelity does not allow the Fidelity Freedom index funds within 401(k) plans, that would not excuse a plan sponsor ignoring the findings from the AMVR forensic analyses. Fidelity clearly had more prudent investment options available. Fidelity apparently simply chose not to offer them to CommonSpirit to financially benefit their own investment company.
As SCOTUS stated in its Northwestern University decision, each individual investment option must be prudent. A plan sponsor has an ongoing duty to monitor all investment options offered within its plan and promptly remove any imprudent option.
Fidelity’s Contrafund fund (Contrafund) has long been one of Fidelity bellwether funds, both in retail accounts and pension plans. Of note, Morningstar recently downgraded the fund.
Fidelity created a series of index funds to compete with Vanguard’s popular index funds. Fidelity’s index funds have proven to be a true competitor to Vanguard’s index funds, both in terms of price and performance.
Morningstar rates Contrafund as a large cap growth (LCG) fund. Fidelity offers a comparable LCG index fund. Using the AMVR metric, a forensic analysis comparing the two LCG Fidelity funds provided some interesting results.
Once again, the actively managed Fidelity fund proved to be imprudent relative to a comparable Fidelity index fund. Keep in mind, in assessing the damages of a fiduciary breach, the underperformance of an actively managed fund is properly considered as an opportunity cost. Therefore, the underperformance is combined with the incremental costs of the actively managed funds in computing potential damages resulting from a fiduciary breach.
Rethinking the Fiduciary Disclaimer Clause During my fiduciary audits of 401(k) and 403(b) plans, I always review the plan’s advisory contract. More often than not, I find that the plan advisor has inserted a fiduciary disclaimer clause in the contract. As a result, the plan advisor will claim that any advice and services that they provide to a plan is not required to meet the stringent fiduciary standard’s loyalty and prudence requirements.
More often than not, I find that the advice and services provided by the plan advisor has definitely not met such standards. As a result, the plan sponsor is left fully exposed for all fiduciary liability.
When I point out the fiduciary disclaimer clause in their advisory contract and its implications, the plan sponsor will quickly claim that they were not aware of such language and would never have agreed to such conditions. The challenge for plan sponsors is in detecting such language, as it rarely clearly set out.
Fiduciary disclaimer language is often buried within the advisory contract and stated in such a way as not to arouse suspicion. An example of some commonly used language is often along the line of
“Plan, plan sponsor and plan adviser hereby acknowledge and agree that plan adviser shall only provide advice to the plan and plan sponsor, and that plan and plan sponsor alone shall be responsible for making the ultimate responsibility as to whether to implement plan advisers’ advice and recommendations, in whole or in part.”
Translated – we disclaim all fiduciary responsibilities regarding the plan, plan sponsors, or any plan participants. Fiduciary disclaimer clauses are often, but not always, expressed in negative terms, what they will not provide.
People often accuse me of picking on Fidelity in connection with 401(k) and 403(b) plans. Let me be clear, Fidelity has some excellent products. In taking advantage of a fiduciary disclaimer clause to avoid any fiduciary liability by only offering 401(k) and 403(b) plans, they are simply doing what plan sponsors should be doing – protecting their best interests. That said, plan sponsors may still have recourse against plan advisers and providers. through the courts plan sponsors based on legal grounds such as breach of contract, negligence, and fraud
Liability-Driven 401(k) Plan Design My experience has been that plan sponsors rarely consult with ERISA attorneys regarding fiduciary risk management and designing a liability-driven plan, a win-win plan that both reduces their personal risk while also ensuring a plan that genuinely promotes and protects the best interests of their plan participants.
Marcia Wagner is one of America’s top ERISA attorneys. I first heard about the liability-driven ERISA plan design concept when I read an excellent Lexis-Nexis article she co-wrote with Barry Saelkin. The article itself focused on using the liability-driven concept in selecting investments for defined benefit plans. As I read the article, I realized how perfectly the concept dovetailed with the AMVR metric in connection with defined contribution plans.
Two key points from the article regarding liability-drive plans:
(1) plan sponsors should always employ effective “de-risking” techniques and strategies to minimize the potential liability exposure they may face from selecting and monitoring investment options within a plan; (2) plans should always hire independent and experienced outside experts to help them design, monitor and maintain an effective liability-driven plan.
Ask any experienced ERISA attorney and they will tell you that most ERISA plans will mistakenly tell you that they are ERISA compliant. Plan sponsors and plan investment committees quickly realize otherwise when I show them the results of my AMVR forensic analyses and my fiduciary prudence audit.
Plan sponsors typically ask what they could have/should have done differently. In addition to having originally designed the plan using liability-driven concepts, I usually remind them that the plan adviser/provider would have been a co-fiduciary with the same fiduciary liability responsibilities and exposure – had the plan not released them from such duties by virtue of the fiduciary disclaimer clause. The clause arguably allowed them to provide the plan with imprudent, substandard advice and services – with arguably no liability to the plan.
Going Forward I am a firm believer in the liability-driven plan concept for fiduciary accounts, including 401(k) and 403(b) plans. Plan advisers typically emphasize the nominal returns of their recommendations, with little or no discussion of the potential risks and liabilities associated with such recommendations, e.g., excessive volatility, overall cost-inefficiency, and other unsuitability concerns. The liability-driven plan concept should be even more appealing as the number of ERISA actions continue to increase.
The bad news is that most plans have no idea just how much potential personal liability is hidden in their current plan. The good news is that it is relatively easy to design, implement and maintain a liability-driven 401(k) or 403(b) plan. Furthermore, by using liability-driven concepts to “de-risk” a 401(k)/403(b) plan, a plan can be designed to provide significant benefits for both plan sponsors (risk management and reduced potential liability exposure) and plan participants (improved investment performance).
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
In the midst of chaos, there is also opportunity – Sun Tzu
As an ERISA attorney, the Sixth Circuit’s recent CommonSpirit Health (CommonSpirit) decision1 concerns me. First, the Court completely ignored the First Circuit’s Brotherston decision2, the Restatement (Third) of Trusts (Restatement), and SCOTUS’ subsequent denial of Putnam’s appeal of that decision.
Second, the fact that the CommonSpirit decision has revived the meritless “apples and oranges” argument regarding fiduciary prudence, even though both the Brotherston decision and SCOTUS’ denial of cert discredited such an argument. As a result, the Sixth Circuit has arguably created an unnecessary divide within the circuits.
Upon a recent re-reading of the CommonSpirit decision, I realized that the Sixth Circuit may have actually provided a valuable opportunity to provide more certainty for plan sponsors and to clarify the guidelines going forward for 401(k)/403(b) administration and litigation.
Brotherston v. Putnam Investments, LLC
The Restatement calls “for determining whether and in what amount the breach has caused a `loss’ . . . by reference to what the results `would have been if the portion of the trust affected by the breach had been properly administered.'”3
Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes “return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).”4 (citing § 100 cmt. b(1)
ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for “any losses to the plan resulting from each such breach.” Certainly this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent “to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.”5 (cjtes omitted)
And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts. (citing Varity Corp. v. Howe, 516 U.S. 489, 496-97, 502, 506-07 (1996) (relying on “ordinary trust law principles” to fill gaps created by ERISA’s lack of definition regarding the scope of fiduciary conduct and duties).6
[T]he burden of showing that a loss would have occurred even had the fiduciary acted prudently falls on the imprudent fiduciary. By allowing its analysis on loss to be driven by its concern regarding the objective prudence of the Putnam funds, the district court in essence required plaintiffs to show causation as part of its case on loss-even as it correctly sought to reserve that requirement to defendants.7
So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes).8
In concluding, Judge Kayatta made two significant points:
The Supreme Court has time and again adopted ordinary trust law principles to construe ERISA in the absence of explicit textual direction.9
[T]he Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits…. In other words, Congress sought to offer beneficiaries, not fiduciaries, more protection than they had at common law, albeit while still paying heed to the counterproductive effects of complexity and litigation risk.10
CommonSpirit Health
Trust law informs the duty of prudence, as “an ERISA fiduciary’s duty is derived from the common law of trusts.”11
[The federal pleading] rules require the plaintiff to provide sufficient “facts to state a claim to relief that is plausible on its face.” Plausibility requires the plaintiff to plead sufficient facts and law to allow “the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” “The plausibility of an inference depends on a host of considerations, including common sense and the strength of competing explanations for the defendant’s conduct.”12
Even if CommonSpirit did not violate a fiduciary duty by offering actively managed plans in general, it is true, the company still could violate ERISA by imprudently offering specific actively managed funds. ERISA, in other words, does not allow fiduciaries merely to offer a broad range of options and call it a day. While plan participants retain the right to choose which fund is appropriate for them, the plan must ensure that all fund options remain prudent options.13
Nor does a showing of imprudence come down to simply pointing to a fund with better performance. We accept that pointing to an alternative course of action, say another fund the plan might have invested in, will often be necessary to show a fund acted imprudently (and to prove damages). But that factual allegation is not by itself sufficient. In addition, these claims require evidence that an investment was imprudent from the moment the administrator selected it, that the investment became imprudent over time, or that the investment was otherwise clearly unsuitable for the goals of the fund based on ongoing performance.14
That is why disappointing performance by itself does not conclusively point towards deficient decision-making, especially when we account for “competing explanations” and other “common sense” aspects of long-term investments. In context, such allegations standing alone do not move the claim from possible and conceivable to plausible and cognizable.15
We would need significantly more serious signs of distress to allow an imprudence claim to proceed….publicly available performance information about an investment may show sufficiently dismal performance that this reality, when combined with ‘allegations about methods,’ will successfully allege that a prudent fiduciary would have acted differently.16
An Opportunity Out of Chaos? Most 401(k) litigation focuses on the nominal returns of the investment options within a plan. Both the First Circuit and the Sixth Circuit agree on the importance of trust law in interpreting ERISA. As the Brotherston decision points out, the Restatement explicitly authorizes the use of index funds as comparators, discrediting the “apples and oranges” argument.
However, the Restatement provides other valuable guidelines in determining fiduciary prudence. Section 90 of the Restatement sets out several relevant cost-efficiency standards in determining whether a fiduciary has fulfilled its fiduciary duty of prudence, including
A fiduciary has a duty to be cost-conscious.17
A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.18
Actively managed mutual funds that are not cost-efficient, that cannot be “justified by realistically evaluated expectations” to provide a commensurate return for the additional costs abd risks typically associated with active management are imprudent.19
Given these guidelines, the research on the cost-efficiency of actively managed mutual funds suggest that plan sponsors face a daunting challenge in trying to justify the inclusion of actively managed mutual funds in a 401(k) plan:
99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.20
Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.21
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.22
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.23
However, the Sixth Circuit insisted on “more serious signs of distress” and the use of publicly available performance information to show “sufficiently dismal performance” to establish that a plan sponsor breached their fiduciary duties
The Active Management Value Ratio™ I have suggested for some time that the Active Management Value Ratio (AMVR) is a valuable tool in analyzing the prudence of plan sponsors and other investment fiduciaries. The CommonSpirit decision seems to be the perfect opportunity to prove my assertions.
As I have noted in previous posts on this site, the AMVR is based on the investment research of investment notables such as Nobel Laureate Dr. William F. Sharpe, Charles D. Ellis, Burton L. Malkiel, and Ross Miller. The fundamental premise behind the AMVR is cost-efficiency, a criticial factor in assessing fiduciary prudence under the Restatement.
As Ellis has consistently suggested,
So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!24
A sample of an AMVR analysis supports Ellis’ position.
When I perform an AMVR analysis, I provide two sets of numbers, one set being based on the funds’ nominal, or publicly reported, numbers, the other set being based on the funds’ correlation-adjusted costs and risk-adjusted returns. Experience has shown that the investment and 401(k) industries typically prefer the nominal numbers, while ERISA plaintiff attorneys prefer the adjusted numbers.
The AMVR is simple and straightforward, requiring only the ability to compare the data between an actively managed fund and a comparable index fund by simple subtraction. A plan sponsor, or any other investment fiduciary, then just has to answer two simple questions:
Did the actively managed funds provide a positive incremental return?
If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs?
If the answer to either question is “no,” then the actively managed fund is cost-inefficient/imprudent relative to the comparable index fund.
The AMVR slides speak for themselves. Situations where an investment’s incremental costs exceed its incremental returns is never a desirable, or prudent, investment scenario. Cost-inefficient investment alternatives within a 401(k) plan are not legally valid “choices.” Additional details on the calculation and interpretation of the AMVR are available on this website.
In CommonSpirit, the primary issue was the alleged imprudence/ cost-ineffficiency of Fidelity’s Freedom Funds (Active Suite) compared to Fidelity’s Freedom Funds Index Funds. I performed an AMVR analysis on several of the funds to determine the merits of the plaintiffs’ case.
The results of an AMVR analysis on several of the other Freedom funds provide similar results.
The AMVR analyses clearly show that in most cases the Active Suite not only underperformed the comparable index shares, but such opportunity cost/loss was further compounded by the fact that an investor incurred additional incremental costs in connection with such funds, while receiving actually nothing in return for such costs. This is the antithesis of fiduciary prudence.
The situation becomes even worse if the costs are adjusted for the correlation between the active suite funds and the comparable index funds, shown here based on Miller’s Active Expense Ratio (AER). Miller described the importance of the AER:
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.25
The second slide shows just how much of an impact the combination of a fund with high incremental costs and a high correlation of returns can have on the effective costs that an investor pays for a active management, further reducing the cost-efficiency of an investment and overall prudence.
Going Forward: An Opportunity Amidst Chaos The Sixth Circuit has created a division between itself and the First Circuit on the issue of whether index funds are valid comparators, “meaningful benchmarks,” in 401(k) actions. The two circuits do agree with SCOTUS that the common law of trusts provides insight on fiduciary law issues, including on questions involving fiduciary prudence. The two circuits also agree on the importance of costs.
The Restatement is just that, a restatement of the common law of trusts. In Tibble26, SCOTUS specifically noted that the courts often turn to the Restatement for guidance in resolving questions involving fiduciary law, including questions involving ERISA.
As the First Circuit noted, Section 100 the Restatement expressly approves of the use of index funds as comparators in 401(k) litigation. The AMVR can be used by plan sponsors and attorneys to easily prove that in the overwhelming majority of cases, the inclusion of actively managed mutual funds in a 401(k) plan cannot satisfy the Restatement’s requirement that the use of actively managed funds/strategies be justifiable by “realistically evaluated return expectations” of providing a commensurate return for the additional costs and risks associated with active management, are imprudent.
“Wilful blindness” is a legal term often defined as “a conscious avoidance, a judicially-made doctrine that expands the definition of knowledge to include closing one’s eyes to the high probability a fact exists.” Despite acknowledging the importance of the common law of trusts, the Sixth Circuit has seemingly decided to ignore the Restatement’s positions with regard to both index funds as acceptable benchmarks in 401(k) litigation and the concerns over a fiduciary’s use of active management strategies and/or products. However, “facts do not cease exist because they are ignored.”
The Sixth Circuit states asserts that plaintiffs must do more than simply pleading the underperformance of an actively managed fund. Under the federal pleading rules, the Sixth Circuit says that in order to satisfy federal pleading rules, plan participants must plead facts that establish the plausibility, not just the possibility, that a plan sponsor breached of their fiduciary.
The AMVR provides plan plaintiffs and their attorneys with a simple means to provide the “more” that both the Sixth Circuit and the plausibility pleading standard demand. By combining the AMVR with the overwhelming research establishing the cost-efficiency of actively managed, plan participants can establish both the underperformance of actively managed funds, and the resulting cost-efficiency of such funds due to the fact that such funds’ incremental costs exceeding incremental returns, if any, provided by such funds.
The AMVR also eliminates the need for courts and plan sponsors to consider immaterial collateral issues such as a fund’s classification (active, passive, large cap, small cap) and/or investment strategy (growth, income), as the use of cost-efficiency as the comparator cuts across such factors to provide an evaluation based on the stated purpose of ERISA, that being the best interests of the plan participants and their beneficiaries.
The plaintiffs have not announced whether they intend the to appeal the Sixth Circuit’s CommonSpirit decision. I hope that the decision is appealed in order to shift the paradigm in connection with 401(k) plans and to clarify the applicable standards in 401(k) and 403(b) litigation. Such a final resolution would provide much needed clarity for both plan sponsors and the courts as to the applicable guidelines for plan administration and allow plan sponsors to design win-win 401(k)/403(b) plans that actually promote the best interests of both plan participants and plan sponsors.
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
Notes 1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022). (CommonSpirit) 2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston) 3. Brotherston, 31. 4. Brotherston, 31. 5. Brotherston, 31. 6. Brotherston, 33. 7. Brotherston, 34. 8. Brotherston, 36. 9. Brotherston, 36. 10. Brotherston, 37. 11. CommonSpirit, Section II.A. 12. CommonSpirit, Section II.A. 13. CommonSpirit, Section II.A. 14. CommonSpirit, Section II.A. 15. CommonSpirit, Section II.A. 16. CommonSpirit, Section II.A. 17. Restatement (Third) Trusts, Section 90, Introductory Comment. American Law Institute. All rights reserved. (Restatement) 18. Restatement, Section 90 cmt. f. All rights reserved. 19. Restatement, Section 90 cmt. h(2). All rights reserved. 20. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010). 21. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 22. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016. 23. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997). 24. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c. 25. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4. 26. Tibble v. Edison International, 135 S. Ct 1823 (2015).
Whenever plan sponsors and plan advisers talk about 401(k) litigation, they always point the finger at those bad ‘ol ERISA plaintiff attorneys. Since I am one of those bad folks, I respectfully disagree with such sentiments. I respectfully suggest that plan sponsors should look in the mirror to see the real party for such litigation. As the famous comic strip, “Pogo,” once said, “we have met the enemy and he is us.”
Whenever I talk with a CEO and/or a 401(k) investment committee, this is the first graphic I show them.
Most plan advisers insist on plan sponsors agreeing to an advisory contract that contains a fiduciary disclaimer clause. Many plan sponsors are not aware that they have agreed to such a provision since the clauses are usually set out in legalese. But they are usually there.
When a plan sponsor agrees to such a clause, it waives important protections for both itself and the plan participants. With a fiduciary disclaimer clause, securities licensed advisers can claim to be subject to Regulation “Best Interest” (Reg BI) rather than the more demanding duties of loyalty and prudence required under a true fiduciary standard.
Reg BI claims that it requires brokers to always put a customer’s best interests first, including considering the costs associated with any and all recommendations. Then Reg BI turns around and allows brokers to only consider “readily available alternatives,” which the SEC considers to include the cost-inefficient and consistently underperforming actively managed mutual funds and various annuity products that brokers and broker-dealers generally recommend. So, in whose best interests?
Unless a plan sponsor properly performs the investigation and evaluation required under ERISA, this usually results in 401(k) litigation and the plan sponsor settling for a significant amount. As we discussed in a previous post, when you consider that all of this can be easily avoided by a plan sponsor by performing a cost-efficiency analysis using our free Active Management Value Ratio, you have to wonder why plan sponsors do not better protect themselves by simplifying their plans and ensuring that they are ERISA-compliant.
My experience has been that most plan sponsors create unnecessary liability exposure for themselves due to a mistaken understanding of their true fiduciary duties. “The CommonSense 401(k) Plan”™ provides a simple solution that reduces both administration costs and potential liability exposure, resulting in a win-win situation for both plan participants and plan sponsors.
So, for plan sponsors and plan advisers, the next time you point a finger at ERISA plaintiff’s attorney and blame us for the number of 401(k) litigation cases, remember the words of my good friend, Charles Nichols, when you point at us, three of your remaining fingers point back at you.
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
“Facts do not cease to exist because they are ignored” – Aldous Huxley
The Sixth Circuit Court of Appeals’ recent decision in the CommonSpirit Health (CommonSpirit)1 401(k) action has brought renewed attention to several key 401(k) compliance and fiduciary liability issues. While many in the financial services and 401(k) industry have suggested that the decision signifies a new approach to 401(k) litigation, I would argue that that decision is premature.
I have over 27 years of combined experience in securities/RIA/ERISA compliance, I am a firm believer in the value of the black letter law, the actual statutes and regulations that govern an area of the law, as opposed to legal decisions interpreting such laws.
A prime example of that was SCOTUS’ recent decision in the Northwestern University case.2 As the Court pointed out, ERISA’s own language clearly indicated that the Seventh Circuit’s “menu of options” defense had no merit, to the point that Justice Kagan even asked the school’s attorney whether he actually believed his own argument. His answer – “no.”
We now have the same situation presenting itself as a result of the CommonSpirit decision, with the court renewing the anti-index funds “meaningful benchmarks” and “apples and oranges” argument. Both of these arguments were discredited in the First Circuit’s Brotherston decision3, and SCOTUS’ subsequent refusal to hear the case on appeal.
As a result of the CommonSpirit decision, we once again have two federal appellate courts with inconsistent and irreconcilable decisions that threaten the rights and protections guaranteed under ERISA. Fortunately, I would argue that the First Circuit has already provided the answer, stating that
[T]he Restatement specifically identifies as an appropriate comparator for loss calculation purposes’ return rates of one or more…suitable index mutual funds or market indexes….’
ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for ’any losses to the plan resulting from each such breach.’ Certainly this text is broad enough to accommodate the total return principle recognized in the Restatement….And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts.4
ERISA is essentially a codification of the common law of trusts. The Restatement of Trusts essentially reflects the common of trusts. The First Circuit’s points perhaps explain the fact that the Sixth Circuit mentioned neither the Brotherston decision nor the Restatement of Trusts in its CommonSpirit decision.
Nevertheless, the CommonSpirit decision invites a deeper examination of the “why” regarding the current 401(k) litigation trend in general. While the amount of 401(k) litigation is a much-discussed topic, far too often the argument is disingenuous, as it ignores two key facts – most 401(k) plans are non-ERISA compliant due to the amount of cost-efficient and/or “closet index” funds offered within modern 401(k) and 403(b) plans.
Cost-Inefficiency Within Plans Plan sponsors are co-fiduciaries with any plan adviser the plan hires. However, in many cases, the plan adviser will insert a clause in their advisory contract with the plan disclaiming any fiduciary duties in connection with their services to the plan.
I maintain that by agreeing to an advisory contract with such a fiduciary disclaimer clause, the plan sponsor violates their fiduciary duties. My argument is based on the fact that by agreeing to release a plan adviser from their co-fiduciary status and duties, a plan sponsors arguably allows a plan adviser to legally provide a lower quality of advice under the SEC’s Regulation Best Interest (Reg BI) than the adviser would have been required to provide as a fiduciary.
While a true fiduciary standard requires an ERISA fiduciary to always act in the best interest of a plan’s plan participants and their beneficiaries, Reg BI provides advisers with a loophole, the “readily available alternatives” language, which effectively allows an adviser to put the best interest of their broker-dealer and themselves ahead of plan participants and their beneficiaries. This creates an obvious problem, especially when the evidence suggests that many plan sponsors blindly follow their plan adviser’s advice without performing their own legally required investigation and evaluation of a plan’s investment options.
Does a plan sponsor’s agreeing to a fiduciary disclaimer clause allow a plan adviser to recommend imprudent investments for a plan under Reg BI? Does a fiduciary disclaimer clause allow an adviser to deny a plan access to prudent investment alternatives that the adviser actually has available, but simply chooses not to offer to a plan for financial reasons?
Plan advisers typically recommend actively managed investment options because that is how they and their broker-dealers make money. Research has consistently shown that the overwhelming majority of actively maanged mutual funds are cost-inefficient when compared to comparable passively managed index funds.
99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.5
[I]ncreasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge6
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.7
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.8
In an earlier post, I noted that when the Securities and Exchange Commission (SEC) announced and implemented Regulation “Best Interest” (Reg BI), then SEC chairman Jay Clayton acknowledged the importance of cost-efficiency of investments:
rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes utility.9
[A]n efficient investment strategy may depend on the investor’s utility from consumption, including…(4) the cost to the investor of implementing the strategy.10
And yet, as previously mentioned in my last post, the “readily available alternatives” language in Reg BI effectively allows brokers to ignore the cost efficiency issue and promote their own “best interests.”
SCOTUS has consistently recognized the Restatement (Third) of Trusts (Restatement) as a valuable resource in resolving fiduciary questions. The two dominant themes throughout the Restatement are cost-consciousness/cost-efficiency and risk-management through effective diversification.
Section 90 of the Restatement, more commonly known as the Prudent Investor Rule, is often cited in connection with the fiduciary duties of prudence and loyalty. Comment h(2) of Section 90 states that active management funds or strategies are only prudent when it can be objectively predicted that the fund/strategy will an investor with a commensurate return for the additional costs and risks typically associated with active management.
The obviousness and importance of cost-inefficiency within 401(k) plans can be illustrated with two forensic analyses using my Active Management Value Ratio™ (AMVR). The AMVR is based on the research of investment experts such as Charles D. Ellis, Burton L. Malkiel, Nobel Laureate Dr. William D. Sharpe and Ross Miller.
The basic premise is to assess the cost-efficiency of an actively managed mutual fund by comparing the fund’s incremental costs and incremental returns relative to a comparable index fund. Index funds, rather than market indices, are used for comparison purposes since market indices do not allow for cost-efficiency comparisons.
Each year, the retirement shares of Fidelity’s Contrafund Fund (FCNKX) and American Fund’s Growth Fund of America (RGAGX) are rated as within the top funds used in U.S. defined contribution plans. AMVR forensic analysis of both funds is shown below (based on the 5-year period ending on June 30, 2022).
When I perform an AMVR analysis, I report two sets of numbers, one set being based on the funds’ nominal, or publicly reported numbers, the other set being being based on the funds’ correlation-adjusted costs and risk-adjusted returns. Experience has shown that the investment and 401(k) industries typically prefer the nominal numbers, while ERISA plaintiff attorneys prefer the adjusted numbers.
The AMVR slides speak for themselves. Situations where an investment’s incremental costs exceed its incremental returns is never a desirable, or prudent, investment scenario. Cost-inefficient investment alternatives within a 401(k) plan are not legally valid “choices.” Additional details on the calculation and interpretation are available on this website.
The CommonSpirit case provided users of the AMVR with a unique opportunity – the opportunity to compare the cost-efficiency and respective prudence of two competing products offered by the same fund company, in this case Fidelity Investments. The products in this case involved the Fidelity Freedom suite of actively managed target date funds (TDFs) and the Fidelity Freedom Index TDFs.
The AMVR analysis slide comparing the two Fidelity 2035 TDFs is shown below.
Each quarter InvestSense prepares a “cheat sheet” on some of the top non-index funds within U.S defined contribution plans. The “cheat sheet” comparing the remaining Fidelity Freedom active and Index funds is shown below.
In an earlier AMVR analysis, Fidelity Contrafund K shares were compared to Vanguard Large Cap Growth Index shares. An AMVR forensic analysis comparing Contrafund to Fidelity’s Large Cap Growth Index shares is shown below.
So, the AMVR forensic analysis clearly shows that the Fidelity Large Cap Growth Index Fund shares are a more prudent investment option for a 401(k) plan. However, Fidelity does not offer the Large Cap Growth Index Fund to 401(k) plans. Contrafund is obviously more financially lucrative to Fidelity.
Unless Fidelity is in a fiduciary relationship with a plan sponsor, it has no legal obligation to offer their entire product line to 401(k) plans. If Fidelity is in a fiduciary relationship with a plan, an argument can be made that they do have a fiduciary obligation to offer their most prudent investment alternatives to a 401(k) plan.
At the same time, the Contrafund/Large Cap Growth Index fund AMVR analysis puts a plan sponsor in a predicament given the significantly better performance and cost-efficiency of the index fund. Simply because Fidelity refuses to make the better investment alternative available to a plan does not legally justify selecting the inferior investment alternative and causing the plan participants unnecessary losses. That would obviously constitute a breach of the plan sponsor’s fiduciary duties.
Closet Indexing
[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….11
Closet indexing raises important legal issues. Such funds are not just poor investments; they promise investors a service that they fail to provide. As such, some closet index funds may also run afoul of federal securities laws.12
Closet indexing is an international issue. As set out above, the issue is simple – are investors in actively managed mutual funds getting what they were promised, active management, or simply overpaying for the same performance they could receive from less costly index funds.
Professor Ross Miller did a study on the impact of closet indexing, focusing primarily on the relationship between an actively managed mutual fund’s r-squared number, “closet index” status, and the resulting overall financial impact of the two. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but who charge much higher fees than the index fund. The higher an actively managed fund’s r-squared number, the greater the likelihood that the actively managed fund can be classified as a closet index fund.
An r-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to the performance of a comparable index fund, rather than the active fund’s management team.
There is no universally agreed upon level of r-squared that designates an actively managed mutual fund as a closet index fund. I use an r-squared correlation number of 90 as my threshold indicator for closet index status. Others, including Morningstar, use much lower r-squared numbers.
Miller’s findings were extremely interesting.
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.13
As the AMVR and “cheat sheet” slides provided herein show, once correlations of returns is factored into the cost-efficiency equation, the effective expense ratios investors pay increase substantially, resulting in significantly lower overall cost-efficiency.
Going Forward As a risk management consultant, I advise plan sponsors and other investment fiduciaries on compliance and “best practices” issues. I constantly stress to them the importance of exposing and eliminating cost-inefficiency and closet indexing within a 401(k) plan.
I often explain the relationship between cost-efficiency and fiduciary prudence/risk management with the following illustration.
As plan sponsors and investment fiduciaries increase the cost-efficiency within their plan, the level of fiduciary prudence increases, reducing their potential fiduciary liability exposure.
I believe that the CommonSpirit decision will eventually be vacated for exactly the reasons that the First Circuit set out in the Brotherston decision – SCOTUS’ advice regarding using the Restatement to resolve fiduciary disputes. The Restatement endorses the use of index funds as acceptable and “meaningful” benchmarks in calculating losses and addressing fiduciary breach questions. “Facts do not cease to exist because they are ignored.”
The Active Management Value Ratio™ provides plan sponsors and other investment fiduciaries with a fundamentally sound and simple means of accomplishing these goals using index funds. In so doing, plan sponsors can create and maintain a win-win plan, one that provides genuine benefits for plan participants and protects plan sponsors against unnecessary and unwanted exposure to fiduciary liability.
Notes 1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022). (CommonSpirit) 2. Hughes v. Northwestern University, 142 S.Ct. 737 (2022). 3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018). (Brotherston) 4. Brotherston, 39. 5. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010). 6. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8e 7. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997). 8. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016. 9. SEC Release 34-86031, Regulation Best Interest: The Broker-Dealer Standard of Conduct (Reg BI), 279. 10. Reg BI, 279. 11. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133 (Cremers), 5, 42. 12. Cremers, 5, 42. 13. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought
Having read the CommonSpirit Health (CommonSpirit) decision1 and the related briefs several times, three key fiduciary risk management issues stand out to me with regard to plan sponsors
1. SCOTUS needs to expressly resolve this ongoing “apples and oranges” debate once and for all, to expressly rule on the propriety of using index funds for benchmarking purposes. I believe the Court may legitimately feel that they addressed and resolved the issue by refusing to grant certiorari in the Brotherston decision.2 The Sixth Circuit obviously feels differently, as it resurrected the “apples and oranges” argument in upholding the district court’s dismissal of the case.
In the CommonSpirit decision, neither the circuit court nor the Sixth Circuit acknowledged the First Circuit’s Brotherston decision and/or the court’s reliance on the Restatement (Third) of Trusts’3(Restatement) position on the propriety of using index funds for benchmarking purposes.
“So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100, cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes)”4
Neither court acknowledged SCOTUS’ denial of Putnam’s application for certiorari, which many would interpret as the court’s indication that both the First Circuit’s decision and underlying rationale were correct.
One circuit is not obligated to follow the decisions of another circuit, and laws are obviously open to differing opinions. However, the fact that neither court acknowledged Brotherston nor tried to distinguish the two cases is arguably noteworthy given the First Circuit’s reliance on the Restatement, a resource recognized by SCOTUS as a legitimate resource in resolving fiduciary questions in its Tibble decision.5
Hopefully, the Sixth Circuit’s decision will be appealed. The fact that the case involves the prudence of two competing products from the same mutual fund company makes the case even more appealing for review. As the Solicitor General’s amicus brief in Brotherston argued, the rights and protections guaranteed to employees by ERISA are too important to vary based upon in which jurisdiction employees may reside.
2. The whole “fiduciary disclaimer clause” issue needs to be addressed. More specifically, the question of whether a plan sponsor breaches his fiduciary duties of prudence and loyalty to the plan participants by agreeing to an advisory contract that contains a fiduciary disclaimer clause. Again, I think the CommonSpirit case brings this issue into focus since the case involved similar, yet competing, products offered by the plan adviser, Fidelity Investments.
I think several issues need to be explored and addressed with regard to the use of fiduciary disclaimer clauses in 401(k) plan advisory contracts. It can be argued that removing a plan adviser’s fiduciary obligations allows firms to argue that their advice and recommendations are to evaluated under Regulation Best Interest (Reg BI)6, not a true fiduciary standard.
The resulting quality of advice issues are obvious:
The fiduciary standard requires that an adviser consider the prudence of their actions/recommendations in terms of an “open architecture” platform, or the entire universe of investment options, to ensure that the best interests of the plan participants are genuinely protected.
Reg BI, and its “readily available alternatives” loophole, allows plan advisers to “carve out” a portion of the universe of investment options and essentially put the best interests of the broker-dealer and the plan adviser ahead of those of the plan and its participants.
This result is totally inconsistent with ERISA’s stated purpose and mission, to protect plan participants and retirement plans against any form of inequitable or abusive activity.
In analyzing cases involving fiduciary disclaimer clauses, my initial response is to ask (1) why a plan adviser would even request such a provision, and (2) why would a plan sponsor agree to such a provision.
Releasing a plan adviser from any fiduciary duties or obligations to a plan does not provide any benefits at all to plan participants. Not only does it allow a plan adviser to provide a lesser quality of advice and products pursuant to Reg BI, it also arguably allows them to avoid offering their company’s entire line of financial products to the plan participants, potentially denying the plan participants the opportunity to maximize their potential return by investing in cost-efficient investments. Therefore, agreeing to any plan advisory contract that contains a fiduciary disclaimer clause violates a plan sponsor’s fiduciary duties of loyalty and prudence.
I would argue that prior to agreeing to any fiduciary disclaimer clause, a plan sponsor should consider the fact that the financial services industry has historically opposed any attempt to impose a true fiduciary standard on its members. Could it be because the industry knows that their advice and products typically fall far short of complying with a true fiduciary standard, while Reg BI arguably protects them when providing imprudent advice and/or products?
Section 90, comment h(2), of the Restatement states that that due to the higher costs and risks associated with actively managed funds and active strategies, both are imprudent unless it can be objectively estimated that the funds and/or strategies will provide a commensurate return for the additional costs and risks incurred, i.e., are cost-efficient.7
The financial services industry does not like to discuss cost-efficiency, as studies have consistently shown that the overwhelming majority of actively managed mutual funds are cost-inefficient.
99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.8
Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.9
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.10
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.11
The CommonSpirit case presents a perfect example of this scenario in connection with the comparison between the Fidelity Freedom active suite of target-date funds and the Fidelity Freedom Index target date funds. A forensic analysis comparing the 2035 version of both funds using the Active Management Value Ratio™ clearly shows that the 2035 active version of the funds is cost-inefficient relative to the passive index version.
An AMVR analysis comparing the other Fidelity Freedom active/Freedom Index funds provided similar results
Had the CommonSpirit plan adviser remained subject to a fiduciary standard, it can be argued that the adviser would have been equally legally liable, along with the plan sponsor, for not recommending and selecting the cost-inefficient, i.e., imprudent, funds to the plan. The inability of the plan participants to include the plan adviser in any litigation could also impact their ability to achieve a full and complete recovery for any and damages suffered.
From a strategic standpoint, the inclusion of a claim based on the fiduciary disclaimer theory could also benefit ERISA plaintiff attorneys in preventing dismissal of their cases by creating a genuine and material issue of fact. On ruling on motions to dismiss, judges are required to accept plaintiff’s allegations of fact as true and to base their decisions involving such motions only on questions of law. A basic tenet of the law is that decisions of fact are to be made solely by a jury.
Furthermore, given the fact that the plaintiff will rarely have pre-trial access to the advisory contract between the plan and the adviser, the Leber v. Citigroup 401(k) Investment Committee decision12 should be cited as authority for granting plaintiff’s attorney restricted discovery on the issue of the advisory contract prior to the court deciding a motion to dismiss.
3. When I read the Sixth Circuit’s CommonSpirit decision, two other 401(k) decisions immediately came to mind, Brotherston and Hughes v. Northwestern University.13 The reasons these cases came to mind is that they support my advice to plan sponsors and other investment fiduciaries to follow the actual law, not the interpretations of the law by the courts.
My advice is not meant as disrespect for the courts. My advice is simply meant as a risk reduction reminder to plan sponsors and other investment fiduciaries that courts can, and sometimes do, legitimately interpret the application of the law differently due to a difference in the facts involved in a case.
Courts are also not infallible. As Justice Benjamin Carozo pointed out,
There is in each of us a stream of tendency, whether you choose to call it philosophy or not, which gives coherence and direction to thought and action. Judges cannot escape that current any more than other mortals.
The great tides and currents which engulf the rest of men do not turn aside in their course and pass the judges by.
The law, however, should remain constant. And in interpreting and applying the law, I agree with Justice Cardozo that in many cases, “[t]he risk to be perceived defines the duty to be obeyed.”
In the Northwestern University case, we saw SCOTUS reject the Seventh Circuit’s “menu of options” argument based solely on the wording of ERISA itself. In Brotherston, we saw the First Circuit reject the lower court’s “apples and oranges” argument solely on the wording of Section 100, comment b(1), of the Restatement (Third) of Trusts.
In the CommonSpirit case, we have two Courts of Appeal that have issued two diametrically opposed and irreconcilable decisions involving the same law and the same issue, the propriety of using index funds for benchmarking purposes in determining damages in 401(k) litigation cases.
Only time will tell what the eventual outcome of the case will be. In the meantime, I believe the case provides a valuable lesson as to why plan sponsors and other investment fiduciaries should always focus primarily on the actual laws, not judicial interpretations of such laws
As the Solicitor General pointed out in the amicus briefs filed with SCOTUS in both the Brotherston and Northwestern University cases, inconsistencies between the federal Courts of Appeal is simply one that cannot be allowed to stand, especially in ERISA cases where the financial security of employees and their families are involved.
Notes 1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022). (CommonSpirit) 2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018). (Brotherston) 3. RESTATEMENT (THIRD) TRUSTS, (American Law Institute). (All rights reserved). 4. Brotherston, 39. 5. Tibble v. Edison International, 135 S. Ct 1823 (2015). 6. SEC Release 34-86031, Regulation Best Interest: The Broker-Dealer Standard of Conduct (Reg BI), 279. 7. RESTATEMENT (THIRD) TRUSTS, (American Law Institute), Section 90, cmt h(2). (All rights reserved). 8. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANE 179, 181 (2010). 9. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8e 10. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997). 11. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016. 12. Leber v. Citigroup 401(k) Plan Inv. Committee, 2014 WL 4851816. 13. Hughes v. Northwestern University, 142 S.Ct. 737 (2022).
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought
At the end of each calendar quarter, I perform a forensic AMVR fiduciary prudence analysis on the non-index mutual funds within the top 10 funds in U.S. defined contribution plans, as ranked by “Pensions & Investments.” InvestSense provides both a 5-year and a 10-year analysis, using both a fund’s incremental nominal costs/returns and a fund’s incremental AER/correlation-adjusted costs and incremental risk-adjusted returns.
Studies have consistently shown that the overwhelming majority of actively managed mutual funds are cost-inefficient. A cost-inefficient mutual funds is never in an investor’s “best interest.” Therefore, a fiduciary that selects cost-inefficient fund would violate his/her fiduciary duty of prudence.
Past AMVR analyses have generally confirmed the studies that have found the majority of actively managed funds to be cost-inefficient. InvestSense uses a fund’s incremental AER/correlation-adjusted costs and incremental risk-adjusted return in assessing a fund’s Fiduciary Prudence Rating.
None of the funds qualified as prudent using the 5-year analysis. The Dodge & Cox Stock fund’s nominal nominal numbers would have qualified as prudent. However, the fund failed to produce a positive incrmental return using the fund’s risk-adjusted return.
The 10-year analyses did produce one fund, the Vanguard PRIMECAP Fund (Admiral shares), that qualified as a prudent performance using the fund’s adjusted costs and returns.
The results of the analyses continue to show the harmful effects of a combination of high incremental costs and high r-squared correlation numbers. A prime example of this is the T. Rowe Price Blue Chip Growth fund, where the combination of high incremental nominal costs (1.17) and a high r-squared number (98) resulted in the fund’s incremental correlation adjusted cost increased to 9.31. Very few actively managed will ever provide incremetnsl returns to cover such a deficit.
Recently, the Sixth Circuit handed down its decision in the Smith v. CommonSpirit Health (“CommonSpirit) 401(k) action.1 My immediate reaction was “hello again SCOTUS,” as once again we have inconsistent and irreconcilable rulings between two circuits involving ERISA litigation
The decision raises a number of issues, including the Court’s suggestion that the alleged popularity of a fund has any relevance whatsoever in connection with the legal prudence of such fund. However I want to focus on what I consider to be the primary reason for the increase in 401(k) litigation and the simple solution that would provide a win-win situation for both plan sponsors and plan participants going forward, reducing litigation and its associated costs.
As the Solicitor General pointed out in the amicus brief it filed in connection with Brotherston v. Putnam Investments, LLC,2 (Brotherston) case, the rights and protections guaranteed under ERISA are simply too important to be determined on the basis of the jurisdiction in which a plan participant resides. And yet, just as in the Northwestern University 401(k) case3, that is exactly the situation we now face as a result of the CommonSpirit decision
SCOTUS denied Putnam’s request for certiorari, thereby arguably implicitly, if not expressly, agreeing with the First Circuit’s decision and the reasoning behind the decision. The Brotherston decision clearly discredited the lower court’s reliance on the “apples and oranges” defense, the suggestion that the use of index funds for benchmarking purposes is legally inappropriate due to inherent differences between active and index funds.
SCOTUS has made it clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.”4
So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes)”5
The First Circuit stated that while courts may determine questions of law, the lower court had effectively decided questions of fact, which is the exclusively the responsibility of a jury.
The Court then went on to suggest a way that 401(k) plans might avoid such litigation going forward:
Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”6
In the CommonSpirit decision, the Sixth Circuit ignored both the Brotherston decision and the Restatement (Third) of Trusts, a resource that SCOTUS has acknowledged as a resource in resolving questions involving fiduciary prudence. The Sixth Circuit’s primary basis for dismissing the action was its position that index funds are not a “meaningful benchmark” for determining the fiduciary prudence of an actively managed mutual funds.
We accept that pointing to an alternative course of action, say another fund the plan might have invested in, will often be necessary to show a fund acted imprudently (and to prove damages). But that factual allegation is not by itself sufficient.7
That court explained that the two general investment options “have different aims, different risks, and different potential rewards that cater to different investors. Comparing apples and oranges is not a way to show that one is better or worse than the other.”8
That a fund’s underperformance, as compared to a “meaningful benchmark,” may offer a building block for a claim of imprudence is one thing. But it is quite another to say that it suffices alone, especially if the different performance rates between the funds may be explained by a “different investment strategy….”We would need significantly more serious signs of distress to allow an imprudence claim to proceed.9
The Sixth Circuit then went on to suggest that the alleged popularity of a fund and/or its Morningstar rating may be relevant in determining the prudence of a fund. This suggestion is clearly in conflict with other courts, which have consistently stated that the alleged popularity of a fund and/or third-party ratings are totally irrelevant in determining the fiduciary prudence of mutual funds.
The Court then stated that
publicly available performance information about an investment may show sufficiently dismal performance that this reality, when combined with “allegations about methods,” will successfully allege that a prudent fiduciary would have acted differently.10
The Court credited CommonSpirit with removing the AllianzGI Fund as an investment option in 2018, stating that is served as evidence “that CommonSpirit fulfilled its ‘continuing duty to monitor trust investments and remove imprudent ones’.11The Court apparently was unaware that the AllianzGI Fund was apparently closed in 2018, so it is possible that CommonSpirit had a choice in removing the fund from the plan’s menu of investment options
Building a Better, and Fairer, Mousetrap While most 401(k) decisions address costs and returns, I have never seen any court take the next, and to me the obvious, step of combining the two to address the cost-efficiency of an actively managed fund relative to a comparable index fund.
Interestingly enough, the Sixth Circuit referenced Charles D. Ellis’s classic book, “Winning the Loser’s Game.” Unfortunately, the Court failed to reference arguably Ellis’ most important contribution to wealth management:
So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns.
When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!12
Add to that the contributions of both Nobel Laurerate Dr. William D. Sharpe and investment icon Burton L. Malkiel:
[T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.13
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.14
Based upon the Restatement and the studies of Ellis, Sharpe, and Malkiel, I created a simple metric, the Active Management Value Ratio™ (AMVR), that allows investors, investment fiduciaries and attorneys to quickly determine the cost-efficiency of an actively managed mutual fund relative to a comparable index fund. For more information about the AMVR, including the calculation process, click here (iainsight.wordpress.com).
Once the AMVR is calculated for an actively managed fund, the investor or investment fiduciary only needs to answer two simple questions:
(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used? (2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?
If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and unsuitable/imprudent according the the Restatement’s prudence standards, and should be avoided. The goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental return), but equal or less than “1” (indicating that the fund’s incremental costs did not exceed the fund’s incremental return).
The AMVR metric provides extremely useful information regarding the cost-efficiency of an actively managed mutual fund using just a fund’s nominal, or publicly reported, costs and returns. However, a cost-efficiency analysis should not end there if one wants a truly accurate cost-efficiency analysis of an actively managed mutual fund.
Professor Ross Miller did a study on the impact of closet indexing, focusing primarily on the relationship between an actively managed mutual fund’s r-squared number, “closet index” status, and the resulting overall financial impact of the two. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but who charge much higher fees than the index fund. The higher an actively managed fund’s r-squared number, the greater the likelihood that the actively managed fund can be classified as a closet index fund.
An r-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to the performance of a comparable index fund, rather than the active fund’s management team.
There is no universally agreed upon level of r-squared that designates an actively managed mutual fund as a closet index fund. I use an r-squared correlation number of 90 as my threshold indicator for closet index status. Others, including Morningstar, use much lower r-squared numbers.
Miller’s findings were extremely interesting, namely that
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.15
As a result of his study, Ross Miller, created the Active Expense Ratio (AER) metric. What Miller discovered was that once a fund’s r-squared correlation number is factored in, an active fund’s AER, the fund’s implicit, or effective, expense ratio is significantly higher than the fund’s stated expense, often as much as 400-500 percent higher. Investors and investment fiduciaries should remember John Bogle’s advice on investment costs, “you get what you don’t pay for,” as well as the fact that simple mathematics proves that each one percent in fees and expenses reduces an investor’s or fiduciary’s end-return by approximately seventeen percent over a twenty-year time period.16
The AMVR and the CommonSpirit Health Decision The Plaintiffs in the CommonSpirit case did not include a cost-inefficiency argument in their complaint. While the AMVR has gained increasing recognition and support among investment fiduciaries and some plaintiff’s attorneys, many attorney still refuse to even consider the metric. Attorneys often cite the simplicity of the AMVR and the fact that many judges still dislike the use of index funds, particularly Vanguard index funds, as comparators due to their inherent advantages over comparable actively managed funds
First, I believe that the simplicity of the AMVR is one of its main advantages. The AMVR requires very little time to learn and use effectively. The calculations are based primarily on online data from free sites such as morningstar.com and yahoo.finance.com and marketwatch.com. Once one becomes familiar with the AMVR calculation process and downloads the relevant data, the calculations themselves usually take less than a minute or two.
Second, with regard to judges’ resistance to the use of index funds as comparators, I believe that the Brotherston decision and the Restatement (Third) of Trusts clearly establish that index funds, including Vanguard index funds, are “meaningful benchmarks” under the law. The First Circuit and the U.S. District Court for the Southern District of New York17, aka Wall Street’s federal court, have recognized the propriety of benchmarking in connection with 401(k) actions. As a result, I have suggested to attorneys that they should always include a cost-inefficiency claim in their 401(k) actions cases, if for no other reason than to preserve the issue on appeal.
The CommonSpirit decision validates the AMVR and the processes and fiduciary principles upon which it is based. This opinion is based on the Court’s dacknowledgement of the importance of investment costs:
“One feature of the active/passive management debate deserves focus. It is easy for investors at a given time to preoccupy themselves with the present-day or year-to-year value of their portfolio—the part of a financial statement usually placed most squarely in view. But just as compounding can dramatically increase the value of a mutual-fund investment over time, so the costs of that investment can dramatically eat into that investment over time…. Over time, management fees, like taxes, are not trivial features of investment performance.”17
The Sixth Circuit’s acknowledgment of the importance of investment fees and others costs, including the fact that the impact of such fees, like returns, compound over time, cannot be overemphasized. The costs associated with underperformance are obvious and often discussed, both in terms of the financial loss and opportunity costs.
Costs and cost-efficiency generally do not receive the same amount of attention that returns receive. When the Securities and Exchange Commission (SEC) announced and implemented Regulation “Best Interest” (Reg BI), then SEC chairman Jay Clayton acknowledged the importance of cost-efficiency of investments:
rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes utility.18
[A]n efficient investment strategy may depend on the investor’s utility from consumption, including…(4) the cost to the investor of implementing the strategy.19
The financial services industry quickly announced its opposition to Reg BI. The financial services industry opposition was based largely on the regulation’s requirement that costs must be factored into any investment recommendation provided my brokers.
Section 90, comment h(2) of the Restatement states that that due to higher costs and risks associated with actively managed funds, actively managed funds are imprudent unless it can be objectively estimated that the funds will provide a commensurate return for the additional costs and risks incurred, i.e., are cost-efficient.20
The financial services industry does not like to discuss cost-efficiency, as studies have consistently shown that the overwhelming majority of actively managed mutual funds are cost-inefficient.
99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.21
Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.22
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.23
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.24
Critics of the AMVR often claim that it is simply a way to promote Vanguard funds. The CommonSpirit decision provided me with an opportunity to discredit that allegation by performing an AMVR forensic fiduciary prudence analysis comparing some of the the Fidelity Freedom active funds to comparable Fidelity Freedom Index funds.
I decided to also perform a similar AMVR fiduciary prudence analysis comparing some of the Fidelity Freedom active funds to comparable Vanguard TDF funds.
In the Fidelity Freedom active/inedx analysis, the active funds failed to provide a positive incremental return. So, arguably, the Fredom Active/Freedom Index AMVR analysis would have helped the plaintiff in the CommonSpirit case establish the cost-inefficiency of the active suite of funds, the “more” that courts keep demanding in meeting the required plausibility pleading standard. Conversely, the Fidelity Freedom active/Vanguard TDF AMVR analysis shows the importance of selecting the appropriate comparator index funds, as using Vanguard’s comparable index funds would have undermined the plaintiff’s case.
Going Forward I would argue that there are several issues with the Sixth Circuit’s CommonSpirit decision. However, I believe the bigger issue in connection with 401(k) litigation and fiduciary in general is the opportunity it provides to divert attention from the active/passive debate and place the attention to a much more meaningful issue, the value of cost-efficiency and the AMVR in assessing fiduciary prudence/ liability and determining damages and in 401(k)/fiduciary actions. The simplicity and straightforward nature of the AMVR, combined with the fact that it is consistent with the fiduciary standards established by the Restatement, suggest that it is a “meaningful benchmark” that so many courts require to meet the federal pleading standards.
The AMVR exposes the irrelevancy of the defenses courts and the financial services industry often cite in 401(k) actions in defense of active management, e.g., differences in strategies, methodolgy, goals. The AMVR counters such arguments and tangential issues, essentially saying “ I do not care HOW you allegedly provided me with a benefit, but whether you actually DID provide me with a benefit at all.”
Businesses uses cost-benefit analysis every day. The AMVR is simply the cost/benefit equation using incremental cost and incremental returns as the imputs.
The Brotherston and Leber25 decisions, along with the Restatement effectively rebut any suggestions that index funds, including Vanguard index funds, are not “meaningful benchmarks.” The focus of the courts should be determining whether 401(k) plans provided plan participants with “meaningful choices” within their plans, cost-efficienct investment options that provided genuine benefits to the plan participants and their benefits as required by ERISA.
In closing, I think the validity and the value of the AMVR can be summed up in two relevant quotes. In a 2007 speech at the University of Pennsylvania Law School, Brian G. Cartwright, then general counsel of the SEC, asked his audience to think of an investment in a mutual fund as a combination of two investments: a position in an “virtual” index fund designed to track the S&P 500 at a very low cost, and a position in a “virtual” hedge fund, taking long and short positions in various stocks. Added, together, the two virtual funds would yield the mutual fund’s real holdings. Cartwright told the students,
The presence of the virtual hedge fund is, of course, why you chose active management. If there were zero holdings in the virtual hedge fund — no overweightings or underweightings — then you would have only an index fund. Indications from the academic literature suggest in many cases the virtual hedge fund is far smaller than the virtual index fund. Which means…investors in some of these … are paying the costs of active management but getting instead something that looks a lot like an overpriced index fund. So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether or not they’re getting the desired bang for their buck?26
The second quote is from John Langbein, who served as the Reporter on the committee that wrote the Restatement (Second) of Trusts over fifty years ago. Shortly after the release of the revised Restatement, Langbein wrote a law review article on the new Restatement. At the end of the article, he made a bold prediction:
When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.27
I would suggest that that day has arrived and that the AMVR will be an indispensable tool in making both speaker’s predictions become reality for the benefit of both investors and investment fiduciaries.
Notes 1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022).(CommonSpirit) 2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018)(Brotherston) 3. Hughes v. Northwestern University, 142 S.Ct. 737 (2022) 4. Brotherston, 37 5. Brotherston, 34 6. Brotherston, 39 7. CommonSpirit, II.A 8. CommonSpirit, II.A 9. CommonSpirit, II.A 10. CommonSpirit, II.A 11. CommonSpirit, II.A 12. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c 13. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm 14. Burton G. Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460. 15. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926 16. Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”), http://www.gao.gov/new.item/d0721.pdf 17. CommonSpirit, I.A 18. SEC Speech: The Future of Securities Regulation: Philadelphia, Pennsylvania: October 24, 2007 (Brian G.Cartwright).(SEC Speech) http://www.sec.gov/news/speech/2007/spch102407bgc.htm 19. SEC Speech 20. RESTATEMENT (THIRD) TRUSTS, (American Law Institute), Section 90, cmt h(2). 21. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANE 179, 181 (2010) 22. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8e 23. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997) 24. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016 25. Leber v. Citigroup 401(k) Plan Inv. Committee, 2014 WL 4851816 26. SEC Speech: The Future of Securities Regulation: Philadelphia, Pennsylvania: October 24, 2007 (Brian G. Cartwright). http://www.sec.gov/news/speech/2007/spch102407bgc.htm 27. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought
The Prudent Investment Fiduciary Rules 
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