James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®
Fiduciary Duty to Coduct Independent Investigation and Evaluation The courts have consistently held that plans have a fiduciary duty to conduct an independent and objective investigation and evaluation of the each investment included in a plan.
It is by now black-letter ERISA law that ‘the most basic of ERISA’s investment fiduciary duties [is] the duty to conduct an independent investigation into the merits of a particular investment.’ The failure to make any independent investigation and evaluation of a potential plan investment’ has repeatedly been held to constitute a breach of fiduciary obligations.1
A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.2 The determination of whether an investment was objectively imprudent is made on the basis of what the trustee knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate.3 (emphasis added)
Further complicating the situation is that there is ample evidence that plan sponsors often blindly rely on their plan adviser’s recommendations rather than perform their legally required investigations, even though the courts have consistently ruled that such blind reliance is a breach of a plan sponsor’s fiduciary duties, especially when stockbrokers and commissioned salespeople are involved. The courts have taken the position that such compensation issues create an inherent conflict of interest, and that that conflict may prevent an expert from providing the independent and impartial advice needed to ensure that the plan participants best interests are being served.
Blind reliance on a broker whole livelihood was derived from the commissions he was able to garner is the antithesis [of] a fiduciary’s duty to conduct an] independent investigation”4
[A] broker [is] not an impartial analyst. [A] broker [has an incentive to close deals], not to investigate which of several policies might serve the [plan] best. A [broker]…must consider both what plan it can convince the [plan] to accept and the size of the potential commission associated with each alternative.5
In conducting their investigations and evaluations, plan sponsors considering offering indexed annuities within their plan should especially note the “knows or should know” language within ERISA. I can, and have, argued that that language, combined with the language “solely in the interests of the participants and beneficiaries; for the exclusive purpose of providing benefits to participants and their beneficiaries,” and the “sufficient information to make an informed decision” requirement under ERISA 404(c), are the potential Achilles’ heel of plan sponsors in future fiduciary litigation involving annuities.
In conducting their investigation and evaluation and making their final decisions, plan sponsors should consider the following quote from an executive with Northwestern Mutual with regard to indexed annuities:
These products are so complicated that I think it’s a stretch to believe that the agents, much less the clients, understand what they’ve got….The commissions are extreme. The surrender periods are too long. The complexity is way too high.6
MassMutual Financial Group shared similar concerns, so much so that it sent the results of a thirty-year study to its agents comparing the performance of an annuity based on the S&P 500 Index to an actual investment in the index itself. The study factored in the dividends an investor would have received as part of an actual investment in the index. The study also factored in the fact that indexed annuities do not receive the benefit of dividends paid by the annuity’s underlying index. The study assumed that the annuity had a 9.4 percent annual cap on returns.
The study found that over the relevant thirty years:
(1) Investors in the actual S&P 500 Index, with dividends reinvested, would have received an annual return of 12.2 percent. (2) Investors in the S&P 500 Index, without dividends, would have received an annual return of 8.5 percent. (3) Investors in the indexed annuity would have received an annual return of 5.8 percent.7
On a side note, the study also concluded that investors investing in simple Treasury bills would have actually fared better than those investing in the annuity, earning an annual return of 6.4 over the same thirty year period.
Caveat plan sponsors!
Fiduciary Duty to Disclose Material Information
[A] fiduciary is obligated to investigate all decisions that will affect the pension plan, and must act in the best interests of the beneficiaries.8”
The duty of loyalty requires a fiduciary to disclose any material information that could adversely affect a participant’s interests.”9
Information is material “if there is a substantial likelihood that it would mislead a reasonable employee in the process of making an adequately informed decision regarding benefits to which she might be entitled.”10
As the Restatement (Second) of Trusts states:
[The trustee] is under a duty to communicate to the beneficiary material facts affecting the interest of the beneficiary which he knows the beneficiary does not know and which the beneficiary needs to know for his protection in dealing with a third person.11
[The trustee] is under a duty to communicate to the beneficiary material facts affecting the interest of the beneficiary which he knows the beneficiary does not know and which the beneficiary needs to know for his protection in dealing with a third person.12
The duty of loyalty requires a fiduciary to disclose any material information that could adversely affect a participant’s interests. The duty to disclose material information is the core of a fiduciary’s responsibility, animating the common law of trusts long before the enactment of ERISA.13
Under ERISA, the term “material information” refers to any information that could affect a participant’s decision-making regarding their investments. This includes details about the investment options available and the risks and benefits of each option. allowing then to make choices that align with their financial goals and risk tolerance. 14
Sell the Sizzle, Not the Steak Based on my experience as a compliance director and fiduciary risk management consultant, the overwhelming majority of brokers and plan sponsors have no understanding of the methodology required to properly assess the prudence of annuities. More often than not, plan sponsors hear the mantra “guaranteed income for life” and they believe any annuity is prudent.
The mantra is an example of a common sales technique taught to brokers and agents – “Sell the sizzle, not the steak.” Talk up the allege benefits – guaranteed retirement income – and avoid discussing the negative, potential liability aspects of the product. We are seeing a perfect example of that now, as annuity advocates are playing up the benefits of extra income to plan sponsors without addressing the legitimate liability issues, that annuities present for investment fiduciaries, e.g., failure to provide commensurate return, required surrender of both the annuity contract and the accumulated value within the annuity without any corresponding guarantee of receiving a commensurate return, excessive fees. The late Peter Katt, a fee-only insurance adviser, taught me that with regards to insurance products always ask – “At what cost?”
Prior to entering the financial services as a compliance officer, I was a plaintiff’s personal injury attorney. In cases involving potentially significant injuries and monetary damage award, the defendant and their liability carrier will suggest a structured settlement. Structured settlements typically involve a small amoujnt of upfront cash, with the majority of the damages paid in the form of an annuity.
A plaintiff’s attorney has to ensure that the plaintiff actually receives the amount of money represented in the proposed settlement. After a long period of misrepresentations and other abusive practices by the annuity industry, the courts now require that the annuity carrier’s actual out of pocket expenses equal the amount of the proposed settlement.
For instance, annity issuers would often propose a settlement, but then purchase an annity at a substantially lower cost, often through a subsidiary. For example, if a plaintiff’s attorney convinces their client to accept a proposed settlement of one million dollars, only to find out that the liability carrier was able to purchase an annuity for only $250,000, the plaintiff’s atttorney will likely face a malpractice claim.
Therefore, it is absolutely essential that a plaintiff attorney either hire an expert or learn how to perform a forensic analysis of an annuity. I make the same recommendation to my fiducriary risk management clients. I also walk them through the proper process for evaluating annuities, a forensic actuarial breakeven analysis.
A common mistake in performing such an analysis is basing the analysis purely on present value (PV) calculations. PV calculations are important because they factor in the time value of money, that fact that payments to be made in the future are worth less than the same amount today. A sample breakeven analysis involving a $50,000 annuity on a man retiring at age 65 is shown below.
The breakeven analysis is valuable in indicating that based purely on PV calculations, the annuity owner would only have a 30 percent chance to breakeven on an investment in the asmple annuity, i.e., recover his intial capital investment, somewhere around age 92. So, just as in Las Vegas, the odds heqavily favor the “house,” the annuity issuer. As a result, one could legititmately argue that such information constitutes “material information” that a sponsor “should know” and consider in deciding on whether to offer the annity within a plan, since an objective analysis suggests that the odds were heavily against the annuity owner ever breaking even on his investment.
If the annuity provides that any balance remaining in the annuity reverts back to the annuity issuer.at the death of the annuity owner, this may result in a breach of the plan sponsor’s duty of loyalty, since the annuity issuer would thereby receive a windfall at the annuity owner expense. Section 5 of the Uniform Prudent Investor Act states that a fiduciary cannot make decisions that benefit the fiduciary or a third party at the beneficiary’s expense.15
In such situations, it can be argued that the plan sponsor violated their fiduciary duty of loyalty since the odds were in favor of the sannuity issuer realizing a benefit at the annuity owner’s expense, which the plan sponsor knew or should have known by reading the annuity prior to including the annuity within the plan sponsor’s plan. In legal terms, the harm was foreseeable, so fiduciary liability on the plan sponsor is both equitable and an appropriate remedy for the avoidable harm caused.
A prudent plan sponsor cannot fall for the “guaranteed income for life” spiel. As the late Peter Katt, a fee-only insurance adviser, always warned, when assessing insurance products, always include the question – “at what cost?” In this case, factoring in reasonable and objective input data, e.g., retiremeent at age, the odds were against the annuity owner ever breaking even at the time the plan sponsor made their decision, which is the appropriate standard for determining fiduciary prudence.
However, a prudent forensic fiduciary analysis of our sample annuity provides even more support for arguing that the plan spomsor’s decision to offer the annuity within the plan was imprudent. A proper forensic analysis of an annuity factors in mortality rate, the potential that the annuity owner will even receive a commensurate return, i.e., full return of the principal amount originally invested.
Factoring in mortality rate has a dramatic impact on the possibilities of the annuity owner breaking even. In our example, even if the annuity owner lives to be 100 years old, the annuity owner would be approximately $59,000 short of achieving a commensurate return, of beraking even. Mark Twain expressed the sentiment of many investors when he said “I am not so much concernd about the return ON my mooney as I am the return OF my money.”
My experience has been that most people do not work all their lives for the purpose of subsidizing the annuity industry. When an annuity owner annuitizes an annuity, the annuity owner loses ownership and control of both the annuity contract and the balance within the annity. Upon annuitization, the annuity issuer assumes ownership and controasl of both the annuity and the balance within the annuity, subject to the contractual provisions, namely the obligation to make the required payments as set out in the annuity contract.
Factoring in the applicable mortality rate significantly reduces the probability of both the fiduciary prudence of including annuities in pension plans, as well as the likelihood that an annuity owner will not receive a commensurate return. Evaluating the fiduciary prudence of including an annuity within a 401(k) plan or other type of defined contribution plan, based solely on PV, is legally imprudent.
While evaluating the prudence of an annuity purely on the basis of present value calculations is a fiduciary liability trap, present value can be useful to both plan participants and plan sponsors. If an annuity owner decides to sell their annuity, as many do, in most cases the buyer’s offer will be based on the annuity’s present value, not the original price the annuity owner paid. As the sample forensic breakeven analysis shows, the annuity owner can expect to suffer a significant loss from the owner’s intial investment.
Another use of present value is a well-known 30 second Excel “hack” using Microsoft Excel’s Present Value formula (shown under Formulas > Financial) to alert fiduciaries to potential “red flags” of fiduciary imprudence. Using our sample annuity analysis and Excel’s Present Value (PV) function, the input data would be “Rate” (0.06), “Nperiods” (I usually start at 25 and create additional iterations until the PV is equal to or greater than the annuity owner’s initial investment), and “Pmt” to owner, here based on an annual payment of -$3,000 ($50,000 times 6%).
The PV appears underneath the last column. in this case, after 25 years, the PV of the annuity would only be approximately $43,494, well below the original principal contributed. Using this Excel hack, the annuity owner would have to live well past 100 in order to receive a commensurate return on their original investment. Given the odds against anyone living to that age, and the fact that the odds against receiving a commensurate return would be even greater once the mortality risk factor is added, a plan sponsor would be hard pressed to justify the inclusion of the sample annuity in a plan, especially since ERISA does not explicitly require that a plan offer annuities and plan participants could always purchase annuities outside of a plan.
Plan Sponsors and the Art of Cross-Examination The fact that plan sponsors can easily evaluate annuities using a simple PV table and a mortality risk table supports the argument that this is information that a plan sponsor “knew or should have known” as a result of a properly conducted investigation and evaluation, “material information” that a plan sponsor would need to know in order to make an “prudent “decision, as required under ERISA Section 404(c)16
People often ask me to recommend books to teach them how to properly analyze and evaluate annuities. The two books I recommend are Paul Lesti’s “Structured Settlements,” and “Structuring Settlements” by James R. Eck and Jeffrey L. Ungerer. Both are excellent in describing and explaining structured settlements. I prefer the Eck and Ungerer book because of the simple step-by-step worksheets they provide. I use these same worksheets to teach my fiduciary clients. Both books are usually found in law school libraries.
Plan sponsors often ask me what they can do to protect both themselves and their employees. There are no alternatives to having a properly prepared forensic breakeven fiduciary prudence analysis performed, one that factors in both present value and mortality risk. As I tell my fiduciary risk management clients, the most effective risk management strategy is to avoid risk altogether, whenever possible. The InvestSense “KISS – Keep It Simple & Smart” “approach” is shown below.
We provide our clients with a few simple rules regarding the consideration of annuities in their plans:
Don’t consider annuities at all since they are not required to be offered in plans, so total avoidance is the “best practice” for plan sponsors and other investment fiduciaries. What plan participants do or do not want is irrelevant. ERISA only requires that a plan sponsor offer at leaast three well diversified and legally prudent investment options.
To document a prudent process was used in evaluating a annuity for inclusion within a plan, plan sponsors should always insist on a written beakeven analysis factoring in both PV and mortality risk, in case you need exhibits in future litigation.
Plan investment committees should learn how to personally perform a forensic actuarial analysis in order not to be “duped” by the annuity industry’s “sell the sizzle, not the steak” marketing ruse and to demonstrate that a prudent process was followed.
Avoid the guaranted income mantra and consider other viable guaranteed income alternatives, e.g.,bonds, CD’s, and dividends, which can be used to produce a slifetime stream of income without requiring an investor to surrender the asset and effectively subsidize the annuity industry. I have never met a plan participant whose goal was to work and save for the purpose of subsidizing the insurance and annuity industry.
Going Forward In addition to serving as a fiduciary risk management consultant, I also provide estate planning and wealth preservation advice. Annuities are essentially bets, with the annuity issuer betting that the annuity owner dos not live long enough to totally recover their original investment. As the sample analysis shows, the odds usually heavily favor the annuity issuer, resulting in a windfall for the annuity issuer.
Bayesian theory states that the probability of making a correct decision improves with each additional piece of relevant information. Using the sample forensic analysis provided herein and viewing the annity as a bet, we know the following information:
The odds are always heavily in favor of the annuity issuer, not the plan particiapnt, with arguably little chance of the annuity owner receiving a commensuarte return on their original investment.
Annuities are known for assessing excessive fees, further reducing the profitability of annuities.
In order to receive the alleged benefit, a guaranteed stream of income for life, an annuity owner must deplete available estate assets, potentially destroying any estate planning strategies for those wishing to provide for heirs.
Annuties are complex and confusing. Annuities are also for their lack of transparency/disclosure.
In “Thinking in Bets: Making Smaerter Decisions When You Don’t Have All the Facts,”16 Annie Duke suggests that decisions are often evaluated in terms of ultimate results. Duke argues that the prudence of decisions should be evaluated based upon the information avaialble and used at the time the decision is made, which is consistent with the standard used under ERISA. Even at the outset, the odds are heavily in favor of the annuity issuer, not the plan participant, benefiting from the annuity. Such a situation would violate the plan sponsor’s duties of prudence and loyalty. The duty of loyalty requires a plan sponsor to acr solely in the best interest of the plan participants and their beneficiaries.
The annuity industry’s basic pitch is typically along the lines of
How would you like to earn guaranteed retirement income for life. An annuity will guarantee that you will never run out of money. In order to receive this guaranteed stream of income, you will, however, be required to surrender ownership and control of both the annuity contract and the balancce remaining within the annuity, with no guarantee that you will ever receive a commensurate return on your original investment.
I am Scotch-Irish, so the deal offered above would be counterintuitive given the popular Scottish proverb
Get what you can, and keep what you have, that’s the way to get rich.
So, annuities are counterintuitive for us Scots, and should be so for plan sponsors and plan particiapnts/ due to the surrender of an estate asset without a guarantee of a commensurate return. Among estate planning attorney, annuities are also counterintiutive investments. Among estate planning attorneys, annuities are typically referred to as “estate planning saboteurs” since the success of estate plans generally depends on having sufficient assets in the estate to carry out the decedent’s last wishes. Annuities reduce available estate assets, with no guarantee of a commensurate return to replace such estate assets. Annuties are associated with excessive fees, further reducing estate assets.
ERISA provides that in selecting a plan’s investment options and in otherwise managing a plan,
a fiduciary shall discharge his duties …with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.17
The obvious issue is that a prudent man does not voluntarily surrendeer a substantial asset without an expectation of receiving a commensurate return. Annuities do not provide that assurance, at least not without charging yet another excessive fee via a “return of principal” rider, which in itself would violates the fiduciary duty to avoid unnecessary fees. In such situations, prudent people would insist on a commensurate return.
Bottom line – ERISA does not require that a plan offer annuities and annuies, which by their structure, inherently expose plan sponsors to unnecessary liability risk. Since plan participants are free to purchase annuities outside of a plan, the question plan sponsors should always ask before offering any annuity within a 401(k) plan or any other type of defined contribution plan is – “Why go there” The answer – “Don’t go there!”
Annuities are the antithesis of a plan spsonsor’s ERISA fiduciary duties of prudence and loyalty. Many annuity advocates react strongly when I make that statement. When I present the type of objective information contained herein, plan sponsors generally realize the truth in my position.
Annuities are essentially bets…bad bets!
I have previously stated my position with regard to annuities in ERISA plans:
To the extent that an annuity requires the annuity owner to surrender ownership of the annuity contract and conrol of the accumulated value of the annuity to receive the alleged benefit promised by the annuity, with no guarantee of the annuity owner even breaking even/receiving a commensurate return, and the terms of the annuity contract written in such a way as to essentially ensure that the annuity issuer and/or other third parties will reap a windfall at the annuity owners expense, such an annuity is a breach of an investment fiduciary’s duties of loyalty and prudence.
As for all the annuity industry studies and papers referencing what plaintiff’s want as part of plans, just remember this advice I always provide to my fiduciary risk management clients:
A plan sponsor’s fiduciary legal reality is defined by ERISA and the Restatement of Trusts, not by what plan participants supposedly want or what plan advisers and/or consultants may recommend.
Notes 1. Liss v. Smith, 991 F. Supp. 278, 299 (S.D.N.Y. 1998). (Liss), In re Enron Corp. Securities, Derivatives, and ERISA Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003) 2. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983); Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981). 3. 29 U.S.C.A. Section 1104(c) 4. Liss 5. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003). (Gregg) 6. “Why Big Insurers Are Staying Away From This Year’s Hot Investment Product,” Wall Street Journal, D-12, December 14, 2005. (Staying Away) 7. Staying Away 8. Braden v. Wal-Mart Stores, Inc., 590 F. Supp. 2d 1159, 1167 (W.D. Mo. 2008) (Braden) 9. Braden, 1167-68 10. Braden, 1167-68 (W.D. Mo. 2008) 11. Eddy v. Colonial Life Ins. Co. of America, 919 F.2d 747, 750 (D.C. Cir. 1990) (Eddy), In re Enron Corp. Securities, Derivatives, and ERISA Litigation, 284 F. Supp. 2d 511, 546. 556 (N.D. Tex 2003). 12. Eddy, 750 13. Shea v. Esensten, 107 F.3d 625, 628; Eddy v. Colonial Life Ins. Co. of America, 919 F.2d 747, 750 (D.C. Cir.1990). 14. In re Dynergy ERISA Litigation, 309 F. Supp. 2d 861, 884-85 (S.D. Tex 2004), Restatement (Second of Trusts, Section 173, cmt d, (1959) American Law Institute. All rights reserved. 15. Uniform Prudent Investor Act, Section 5. 16. Annie Duke, “Thinking in Bets: Making Smart Decisions When you Don’t have all the Information,” Penguin Publishing Group (2019) 17. 29 U.S.C.A. Section 1104(a).
Copyright InvestSense, LLC 2024. 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.
James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®
A common question I am receiving is “What are the fiduciary liability issues with in-plan annuities?”
A reccent LIMRA study found that plan sponsors are citing a desire to provide retirement income as the primary reason for some plan sponsors showing interest in retirement income inestment options.
Now, as the fiduciary prudence grinch, my initial response is always going to be “Is the specific investmeent and/or expressly required by ERISA?” If the answer is “no,” then my response will always be “Why go there?” Despite the fact that some annuity advocates say my position is cruel, the fact is that plan participants can always purchase an annuity outside of a retirement plan, thereby allowing a plan sponsor to avoid unnecessary fiduciary liability exposure. As my colleague, Nevin Adams, recently posted, simply framing the question in terms of the desirability of guaranteed retirement income is a canard, especially when fiduciary liability is involved.
I believe that the we are on the cusp of seeing plan sponsor fiduciary liability in connection with in-plan annuities develop into a significant fiduciary litigation issue. Judge Barbara Lynn addressed similar issues in her 2018 decision upholding the DOL’s Fiduciary Rule.1 (which the 5th Circuit overruled and then vacated the DOL’s Fiducairy Rule). My belief in the future growth of litigation involving in-plan annuities is even stronger given the fact that I recently participated in a program discussing a probable blueprint for successfully litigating in-plan annuity issues. I am also receiving an increaing number of inquiries from ERISA plaintiff attorneys on the same topic.
As a former plaintiff’s attorney, I am familiar with the insurance industry’s history of advocating for structured settlements whenever a case involves significant injuries and potentially significant damage awards. A structured settlement typically involves an upfront payment, with most of the damages being covered by an annuity.
From a plaintiff atttorney’s viewpoint, the challenge is to insure that any settlement offer results in a fair result, one that provides the plaintiff with a commensurate return for their injuries and related losses. For example, if the insurance company offers a settlement of $1,000, 000 dollars, with a requirement that the settlement involve a structured settlement, the plaintiff’s attorney must verify (1) that the cost of the annuity to the insurance company will actually be $1,000,000, and (2) that the annuity itself is in the client’s best interest, i.e., provide the client with commensurate return. Since attorneys owe their clients the fiduciary duties of loyalty and prudence, failure to verify the two referenced items can result in an attorney being sued for malpractice.
This is exacrly what happened for several years when insurance companies misled plaintiff attorneys and the court as to their costs in purchasing annuities for use in structured setlements. The insurance companies would misquote their costs, while actually purchasing the annuity from an affiliated insurance company, at a much lower cost.
As a result, prudent plaintiff attorneys either learned how to perform breakeven analyses of annuities or hired actuaries to provide and/or confirm, such analyses. While the actual process is relatively easy, my experience has been that very few plan sponsors perform such analyses in connection with deciding whether to offer in-plan annuities within their plan. As a result, I believe we are going to see an uptick in such litigation.
The graphic shown above is a forensic breakeven analysis on a $50,000 fixed annuity with an interest rate of 6 percent. The scenario assumes a plan participant retiring at age 65 and immediately annuitizing his annuity interest. To simplify the analysis, the example does not factor in annual charges/fees. However, plan sponsors and other investment fiducairies should always factor in the impact of such charges/fees, keeping in mind the GAO and DOL studies that found that each 1 percent in fees/charges reduces an investot’s end-return by approximately 17 percent over a twenty year period.2 Plan sponsors should also be alert to the fact that annuity advocates like to engage in semantics to try not to address the topic of costs/fees and other strategies that the annuity industry employs to avoid transparency of costs/fees and the impact of same on an investor’s end-return.
A properly prepared forensic breakeven analysis of an annuity should always factor in both present value and mortality risk. Present value is important not only in terms of factoring in the impact of inflation and the impact of the time value of money, but also because many annuity owners eventually sell their annuity because it is not providing them with the level of additional income needed. The party purchasing an annuity will typically base their offer on the present value of the annuity, not the original purchase price, as well as the present value of the annuity factoring in the mortality risk factor. in the example shown, note the significant difference in the present value calculations and the resulting commensurate return and fiduciary prudence issues.
As the chart shows, based purely on the subject annuity’s calculated present value, this annuity owner would not breakeven until sometime between age 91 and 92. If you factor mortality risk, the annuity owner would have to live well beyond age 100 just to breakeven on their original investment, raising significant commensurate return and potential fiduciary breach issues. The calculated breakeven point in relation to an investor’s life expectancy is a critical consideration on the issue of the prudence of the decision to include any in-plan annuity in the plan at all. If the annuity contained a reverter clause in favor of the iannuity issuer, that would potentially present fiduciary issues in terms of the fiduciary duty of loyalty since the annuity issuer could potentially receive a windfall at the expense of the annuity owner.
So, from a potential litigation standpoint, the basic issue would be whether “guaranteed retirement income” justifies the fact that the plan sponsor chose to offer an annuity which was structured in such a way as to make it unlikely that the plan participant would ever break even on the investment. Even worse in terms of fiduciary loyalty and prudence, an argument could be made that as a result of the plan sponsor’s choice of the annuity, the product’s design increased the likelihood that a third part (the annuity issuer) would eventually benefit at the expense of the plan participant, which would violate the plan sponsor’s duty to act solely in the best interest of the plan’s participants.
Keep in mind that under ERISA, potential plan sponsor fiduciary breaches are evaluated in terms of what the plan sponsor “knew or should have known” as a result of their legally required independent investigation and evaluation of all plan investment options.3 In this case, while a plan sponsor can legitimately argue that no one can predict when a plan participant will die, an legitimate argument can be made that that uncertainty works against a plan sponsor including an in-plan annuity option with a plan, especially when the annuity owner would need to live well beyond the expected life expectancy at that time just to break even, with a resulting windfall in favor the annuity issuer, resulting in potential fiduciary breach of loyalty issues.
People often criticize me for my “Why go there” position. It’s never a sign of indifference. Rather, it’s based on a recognition of and an avoidance of potential fiduciary risk. In this case, that question is very appropriate, especially given the fact that a plan participant wanting to purchase a similar annuity could easily do so outside the plan. Aside from the potential commissions generated by such an annuity, why would a plan adviser ever recommend the purchase of such an in-plan annuity and the potential liability issues?
I see situations like this all the time. The plan sponsor acts out of a desire to help employees, but the plan sponsor does not understand the annuity product and ends up actually hurting their workers financially.
Plan sponsors often ask me what they can do to protect both themselves and their employees. There are no shortcuts to having a properly prepared forensic breakeven fiducairy prudence analysis performed, one that factors in both present value and mortality risk. As I tell my fiduciary risk management clients, the most effective risk management strategy is to avoid risk altogether, whenever possible. The InvestSense “KISS – Keep It Simple & Smart” “approach” is shown below.
Going Forward While “guaranteed retirement income” is tempting, plan sponsors should also ask – “At what cost?” Under both ERISA and the fiduciary standards set out in Section 90 of the Restatement (Third) of Trusts, two key fiduciary prudence questions regarding a plan’s investments are cost-efficiency and commensurate return for the additional costs and risiks assumed by an investor. Additional fiduciary risk management questions plan sponsors should consider include, but are not limited to:
(1) Will in-plan annuity investors be required to surrender control of the annuity and the accumulated value within the annuity as a condition of receiving the “guaranteed retirement income? If so, what assurances are given to the investors with regard to receiving commensurate return on such forfeitures? Are there additional costs involved in receiving a commensurate return? What are the realistic odds of an investor in the plan’s in-plan annuitities actually breaking even?
(2) Does the plan’s in-plan annuity include a reverter clause? If so, to whom does the balance in an annity revert in the event a plan participant does not break even on their investment iin the annuity?
(3) Prior to deciding to include an in-plan annuity within the plan, did the plan sponsor perform a forensic breakeven analysis involving several likely sceanrios to determine the likelihood of investors in the annuity breaking even on their investment?
Notes 1. Chamber of Commerce of the U.S. v. Hugler, 231 F. Supp. 3d 152 (N.D. Tex. 2017) 2. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study). 3. Fink v. National Savs.& Trust Co., 772 F.2d 951, 957 (D.C. Cir. 1985)
Congress passed ERISA in 1974 as a “comprehensive statute designed to promote the interests of employees and their beneficiaries in employer benefit plans.”1
The past fifty years has seen significant changes in the market and in the number and types of investment products. These changes have resulted in the Department of Labor (DOL) proposing several changes to better protect employees and their beneficiaries in furtherance of ERISA’s stated goal and purposes.
Over the last forty years, the retirement-investment market has experienced a dramatic shift toward individually controlled retirement plans and accounts. Whereas retirement assets were previously held primarily in pension plans controlled by large employers and professional money managers, today, individual retirement accounts (“IRAs”) and participant-directed plans, such as 401(k)s, have supplemented pensions as the retirement vehicles of choice, resulting in individual investors having greater responsibility for their own retirement savings. This sea change within the retirement-investment market also created monetary incentives for investment advisers to offer conflicted advice, a potentiality the controlling regulatory framework was not enacted to address. In response to these changes, and pursuant to its statutory mandate to establish nationwide “standards . . . assuring the equitable character” and “financial soundness” of retirement-benefit plans, 29 U.S.C. § 1001, the Department of Labor (“DOL”) recalibrated and replaced its previous regulatory framework. To better regulate conflicted transactions as concerns IRAs and participant-directed retirement plans, the DOL promulgated a broader, more inclusive regulatory definition of investment-advice fiduciary under the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code (“the Code”). Despite the relevant context of time and evolving marketplace events, Appellants and the panel majority skew valid agency action that demonstrates an expansive-but-permissible shift in DOL policy as falling outside the statutory bounds of regulatory authority set by Congress in ERISA and the Code. Notwithstanding their qualms with these regulatory changes and the effect the DOL’s exercise of its regulatory authority might have on certain sectors of the financial services industry, the DOL’s exercise was nonetheless lawful and consistent with the Congressional directive to “prescribe such regulations as [the DOL] finds necessary or appropriate to carry out [ERISA’s provisions].”2
In the decades following the passage of ERISA, the use of participant directed IRA plans has mushroomed as a vehicle for retirement savings. Additionally, as members of the baby-boom generation retire, their ERISA plan accounts will roll over into IRAs. Yet individual investors, according to DOL, lack the sophistication and understanding of the financial marketplace possessed by investment professionals who manage ERISA employersponsored plans. Further, individuals may be persuaded to engage in transactions not in their best interests because advisers like brokers and dealers and insurance professionals, who sell products to them, have “conflicts of interest.” DOL concluded that the regulation of those providing investment options and services to IRA holders is insufficient.3
The DOL recently introduced the Retirement Security Rule (Rule). In proposing the Rule, the DOL specifically questioned the inequitability and imprudence of recommendations of fixed indexed annuities (FIAs) and variable annuities (VAs) in connection with rollovers from qualified plans to individual retirements accounts (IRAs).
I recently addressed these same issues in a recent blog post discussing fiduciary law principles and annuities in general. Annuities are essentially bets, with the annuity issuer betting that the annuity owner will not receive a commensurate return on their original investment, typically resulting in a windfall for the annuity issuer at the annuity owner’s expense. If the annuity investment was made in the context of a fiduciary relationship, such a potential reversion would seemingly constitute a breach of the fiduciary’s duty of loyalty, the duty to act solely in the best interests of the a plan participant and their beneficiaries.
The “best interest” concern with regard to FIAs can be illustrated with one typical scenario, FIAs often combine a “spread” with a cap limiting the amount of return that an FIA can actually realize in one year. Although FIAs and the annuity industry in general rarely discount specifics such as the sperad they assess in connection with FIAs, combinations alleging a spread of 2 percent combined with a cap of 10 percent are common.
While the annuity industry would allege such a combination as a 2 percent spread and a cap of 10 percent. However, as the graphic shows, the actual impact on a FIA owner would be a 20 percent reduction in realized return. (Note: A basis point equals 1/100th of one percent (0.01). 100 basis points equals 1 1 percent.
This is the very type of abuse that led to the DOL’s Rule proposal, due to the complexity of FIAs and the confusing methodologies used in calculating the amount of interest credited to the FIA owner. This becomes even more problematic given the number of studies concluding that the majority of the public is functionally illiterate.
Against that backdrop and the confusion about the ongoing litigation inolving the DOL’s Rule, I constantly get asked for my opinion on the the 5th Circuit’s decision staying the Rule, including an explanation of the cases and how long it will be before these cases and their issues are resolved and plan participants aer fully protected under ERISA.
Naturally, no one can predict when the cases will be resolved and the stay lifted. However, I have found that providing plan sponsors and plan participants with an understandable summary of the decisions to date has been somewhat helpful to them, as they can evaluate the arguments being made and determine where the equities lie..
While everyone seemingly focused on the court’s decision to stay the Rule, then Chief Judge of the Fifth Circuit dissented from the decision to stay the Rule, stating that
The panel’s majority conclusion that the DOL exceeded its regulatory authority by implementing the regulatory package that included a new definition of investment-advice fiduciary and both modified and created new exemptions to prohibited transactions is based on an erroneous interpretation of the grant of authority given by Congress under ERISA and the Code.4
Judge Stewart’s dissent incorporated both his own opinions, as well as those of district court Chief Judge Barbara G.M. Lynn. The fact that Judge Stewart referenced Judge Lynn’s earlier well-reasoned decision upholding the DOL’s Fiduciary Rule is interesting and may prove insightful as the litigation on the Rule winds its way throught the legal system. as Judge Lynn’s opinion addresses and rationalizes some of the key issues involved in the current litigation involving the Rule.
Judge Stewart initially noted the changes in both the market and investment products available since ERISA’s enactment
Over the last forty years, the retirement-investment market has experienced a dramatic shift toward individually controlled retirement plans and accounts. Whereas retirement assets were previously held primarily in pension plans controlled by large employers and professional money managers, today, individual retirement accounts (“IRAs”) and participant-directed plans, such as 401(k)s, have supplemented pensions as the retirement vehicles of choice, resulting in individual investors having greater responsibility for their own retirement savings. This sea change within the retirement-investment market also created monetary incentives for investment advisers to offer conflicted advice, a potentiality the controlling regulatory framework was not enacted to address.5
Judge Stewart then explained that the DOL proposed the Rule to address supposed gaps resulting from such changes over time in order to better protect plan participants, in furtherance of ERIAS’s stated goals.
Despite the relevant context of time and evolving marketplace events, Appellants and the panel majority skew valid agency action that demonstrates an expansive-but-permissible shift in DOL policy as falling outside the statutory bounds of regulatory authority set by Congress in ERISA and the Code. Notwithstanding their qualms with these regulatory changes and the effect the DOL’s exercise of its regulatory authority might have on certain sectors of the financial services industry, the DOL’s exercise was nonetheless lawful and consistent with the Congressional directive to ‘prescribe suchregulations as [the DOL] finds necessary or appropriate to carry out [ERISA’sprovisions].6
One of the main points of contention argued by the majority in deciding to stay the enforcement of the Rule was the proposed changes in the original five-part fiduciary test adopted by the DOL. However, as Judge Stewart points out
For 41 years, the DOL employed a five-part test to determine whether a person is an investment-advice fiduciary under ERISA and the Code, and that test limited the reach of the statutes’ prohibited transaction rules to those who rendered advice “on a regular basis,” and to instances where such advice “serve[d] as a primary basis for investment decisions with respect to plan assets.” See 29 C.F.R. § 2510.3–21(c)(1) (2015). This regulation “was adopted prior to the existence of participant-directed 401(k) plans, the widespread use of IRAs, and the now commonplace rollover of plan assets” from Title I plans to IRAs, thus leaving out of ERISA’s regulatory reach many investment professionals, consultants, and advisers who play a critical role in guiding plans and IRA investments. Fiduciary Rule, 81 Fed. Reg. 20,946.7
ERISA expressly authorizes the DOL to adopt regulations defining ‘technical and trade terms used’ in the statute. 29 U.S.C. 1135 8 @51
In 1975, DOL promulgated a five-part conjunctive test for determining who is a fiduciary under the investment-advice subsection. Under that test, an investment-advice fiduciary is a person who (1) “renders advice…or makes recommendation[s] as to the advisability of investing in, purchasing, or selling securities or other property;” (2) “on a regular basis;” (3) “pursuant to a mutual agreement…between such person and the plan;” and the advice (4) “serve[s] as a primary basis for investment decisions with respect to plan assets;” and (5) is “individualized . . . based on the particular needs of the plan.”9 29 C.F.R. § 2510.3-21(c)(1) (2015).
The rule challenged on appeal addresses these and other changes in the retirement investment advice market by, inter alia, abandoning the five-part test in favor of a definition of fiduciary that includes “recommendation[s] as to the advisability of acquiring . . . investment property that is rendered pursuant to [an] . . . understanding that the advice is based on the particular investment needs of the advice recipient.10
The DOL’s interpretation of “renders investment advice” is reasonably and thoroughly explained. The new interpretation fits comfortably with thepurpose of ERISA, which was enacted with “broadly protective purposes” and which “commodiously imposed fiduciary standards on persons whose actionsaffect the amount of benefits retirement plan participants will receive”. In light of changes in the retirementinvestment advice market since 1975, mentioned above, the DOL reasonably concluded that limiting fiduciary status to those who render investment advice to a plan or IRA “on a regular basis” risked leaving retirement investors inadequately protected. This is especially so given that “one-time transactions like rollovers will involve trillions of dollars over the next five years and can be among the most significant financial decisions investors will ever make.”11@59
Consistent with this broad authority, the DOL granted exemptions for otherwise prohibited transactions in the newregulatory package, but conditioned those exemptions on, among other things,a requirement that the fiduciary take on the same duties of “prudence” and “loyalty” that bind Title I fiduciaries.12 @60
Further, before making the relevant amendments to theexemptions, the DOL comprehensively assessed existing securities regulation for variable annuities, state insurance regulation of all annuities, and consulted with numerous government and industry officials, including the SEC, the Department of the Treasury, and the Consumer Financial Protection Bureau, among others. The DOL found the protections prior to the current rulemaking insufficient to protect investors and acted within its prerogative tomodify the regulatory regime as it deemed necessary.13
In response to the annuity industry’s false claims that the Rule prohibits advisers, agents and broker-dealers from receiving commissions, Judge Stewart refutes such claims by pointing out that
As an initial matter, the DOL’s final rules do not prohibit commissions for broker-dealers. The rules only modify already-existing exemptions from prohibited transactions. As hasbeen the case, if a person or entity qualifies for an exemption, the applicant can still receive commissions and other forms of third party compensation.14 @55
The real reason the insurance/annuity industry adamantly opposes the Rule and any other regulation that iattempts to impose a duty of loyalty or prudence on them is that they fully realize that, as currently structures, their annuities are not in the “best interest” of customers. As a result, they cannot currently pass any true fiduciary standard. I addressed these industry wide “best interest”/fiduciary imprudence issues in a recent post.
The immediate action involves the question of whether the Fifth Circuit met the conditions set out in the Administrative Procedures Act (APA) required for staying the DOL’s Rule, namely that the movant shows (1) a substantial likelihood of success on the merits; (2) a substantial threat of irreparable harm; (3) that the balance of hardships weighs in the movants’s favor; and (4) that issuance of a preliminary injunction will not disservice the public interest.
As to the last requirement regarding disservice of the public interest, a leading ERISA attorney has already suggested that that is exactly what will happen due the Fifth Circuit’s staying the efffectiveness of the Rule., with her observation that “[a]rguably the most impacted parties then are the investors these individuals serve that aren’t provided service as an ERISA fiduciary.”15
In summarizing the current issues involving the majority decision to stay the effectiveness of the Rule, Judge Stewart stated that
Here, in contrast, the DOL has acted within its delegated authority to regulate financial service providers in the retirement investment industry—which it has done since ERISA was enacted—and has utilized its broad exemption authority to create conditional exemptions on new investment-advice fiduciaries. That the DOL has extended its regulatory reach to cover more investment-advice fiduciaries and to impose additional conditions on conflicted transactions neither requires nor lends to the panel majority’s conclusion that it has acted contrary to Congress’s directive.16
As mentioned earlier, Judge Stewart cites district court Chief Judge Lynn’s previous detailed and well-reasoned opinion upholding the Rule. . As to coverage under the Rule and commissions, Judge Lynn stated that :
Plaintiffs argue the Fiduciary Rule exceeds the coverage of ERISA because it imposes fiduciary status on those who earn a commission merely for selling a product, regardless of whether advice is given. Actually, the Fiduciary Rule plainly does not make one a fiduciary for selling a product without a recommendation. The rule states:
[I]n the absence of a recommendation, nothing in the final rule would make a person an investment advice fiduciary merely by reason of selling a security or investment property to an interested buyer. For example, if a retirement investor asked a broker to purchase a mutual fund share or other security, the broker would not become a fiduciary investment adviser merely because the broker purchased the mutual fund share for the investor or executed the securities transaction. Such ‘purchase and sales’ transactions do not include any investment advice component. Because Plaintiffs’ contention is directly contradicted by the plain language of the Fiduciary Rule, the Court rejects it. 17
As to the Rule replacing the original industry five-step fiduciary test’s “regular basis” requirement argument
Plaintiffs argue the first and third prongs of ERISA’s definition of fiduciary require a “meaningful, substantial, and ongoing relationship to the plan,” and that advice must be “provided on a regular basis and through an established relationship,” as had been required by the five-part test. Nothing in ERISA suggests “investment advice” was intended only to apply to advice provided on a regular basis, and the plain language of the first and third prongs do not indicate that an ongoing relationship is required. To the contrary, all three prongs are broad and written disjunctively; a person is a fiduciary if he satisfies any of the three prongs.18
Plaintiffs also claim that the first and third prongs of ERISA’s definition of a fiduciary involve a direct connection to the essentials of plan operation and that management and administration of a plan are central functions; as a result, they argue the second prong must be read consistently with the other two subsections, and a meaningful and substantial role of the fiduciary, that is ongoing, is required. It is true that the first prong addresses management and the third prong addresses administration, but that does not lead to the conclusion advocated by Plaintiffs. The second prong does not require a “meaningful, substantial, and ongoing relationship” with the recipient of the investment advice, nor must such advice be given on a regular basis for the adviser to qualify as a fiduciary. That is not required by the statute, and Plaintiffs’ attempt to read that into the language of the second prong is unpersuasive.19
Plaintiffs argue that because Congress has repeatedly amended ERISA since 1975, without ever amending the five-part test, that test has de facto been incorporated into ERISA by way of ratification. Generally, congressional inaction “deserves little weight in the interpretive process … [and] lacks persuasive significance because several equally tenable inferences may be drawn from such inaction. At the same time, if Congress “frequently amended or reenacted the relevant provisions without change … [Congress] at least understood the interpretation as statutorily permissible.20
The DOL has defined what it means to render investment advice since 1975, and decided its new interpretation is more suitable given the text and purpose of ERISA, along with new marketplace realities. Congress has neither ratified the five-part test nor has it excluded other interpretations not precluded by the statute.21
Plaintiffs argue the DOL’s interpretation of what it means to render investment advice is entitled to no deference, because ERISA requires regular contact between an investor and a financial professional to trigger a fiduciary duty. If anything, however, the five-part test is the more difficult interpretation to reconcile with who is a fiduciary under ERISA. The broad and disjunctive language of ERISA’s three prong fiduciary definition suggests that significant one-time transactions, such as rollovers, would be subject to a fiduciary duty. Under the five-part test, however, such a transaction would not trigger a fiduciary duty. This outcome is seemingly at odds with the statute’s text and its broad remedial purpose, especially given today’s market realities and the proliferation of participant-directed 401(k) plans, investments in IRAs, and rollovers of plan assets to IRAs. An interpretation covering such transactions better comports with the text, history, and purposes of ERISA.22
ERISA was enacted to serve broad protective and remedial purposes; as the Supreme Court explained, “Congress commodiously imposed fiduciary standards on persons whose actions affect the amount of benefits retirement plan participants will receive.”23
On the issue of whether the Rule is consistent with Congress’ intent in enacting ERISA
“remedial statutes are to be construed liberally,24
the DOL may “prescribe such regulations as [it] finds necessary or appropriate to carry out the provisions of [ERISA],” and to “define [the] accounting, technical and trade terms used in [ERISA].”Plaintiffs argue the Fiduciary Rule contradicts congressional intent because it in effect rejects the “disclosure regime established by Congress under the securities laws.” However, ERISA was enacted on the premise that the then-existing disclosure requirements did not adequately protect retirement investors, and that more stringent standards of conduct were necessary.25
Although ERISA includes disclosure requirements, it also imposes “standards of conduct, responsibility, and obligation[s]” for fiduciaries. The DOL’s new rules comport with Congress’ expressed intent in enacting ERISA. As a result of as the rulemaking process, the DOL rejected a disclosure-only regime, finding that disclosure was ineffective to mitigate the problems ERISA sought to remedy.26
The DOL may change existing policy “as long as [it] provide[s] a reasoned explanation for the change … and show[s] there are good reasons for the new policy.27
Here, the DOL concluded that the five-part test significantly narrowed the breadth of the statutory definition of a fiduciary under ERISA, allowing advisers “to play a central role in shaping plan and IRA investments, without ensuring the accountability that Congress intended for persons having such influence and responsibility.” In reversing that approach, the DOL found the Fiduciary Rule more closely reflected the scope of ERISA’s text and purposes. This reasoning, and the rest of what the DOL produced in the administrative record, satisfy the requirement that the agency explain the change.28
As to the fiduciary “best interest” issues with FIAs and VAs, Judge Lynn observed that:
The DOL explained how FIA sales can generate conflicts of interest, and that with increased sales of FIAs there have been additional complaints that the products were sold to customers who did not need them. The DOL noted a perceived relationship between increased sales of FIAs and unusually high commissions, which are typically higher than for fixed rate annuities. The DOL also noted that FINRA and the SEC concluded that FIAs are riskier than fixed rate annuities, citing FINRA’s conclusion that FIAs “are anything but easy to understand” and “give you more risk (but more potential return) than [a fixed rate annuity].29
The DOL found FIAs “are as complex as variable annuities, if not more complex,” that “[s]imilar to variable annuities, the returns of [FIAs] can vary widely, which results in a risk to investors,” and that “[u]nbiased and sound advice is important to all investors but it is even more crucial in guarding the best interests of investors in [FIAs] and variable annuities.” FIA sales are also “rapidly gaining market share compared to variable annuity sales.” The DOL determined that “[b]oth categories of annuities, variable and [FIAs], are susceptible to abuse, and Retirement Investors would equally benefit in both cases from the protections of [BICE].” The DOL also determined that placing FIAs and variable annuities in BICE would “create a level playing field” and “avoid[ ] creating a regulatory incentive to preferentially recommend indexed annuities.”30
The standard for determining whether the DOL’s decision to move FIAs from PTE 84–24 to BICE was arbitrary and capricious is “whether the agency examined the pertinent evidence, considered the relevant factors, and articulated a reasonable explanation for how it reached its decision.” The administrative record shows the DOL met this standard.31
The DOL described the complexity of FIAs in its Regulatory Impact Analysis (“RIA”). The RIA explained that FIAs generally provide “crediting for interest based on changes in a market index,” but noted there are hundreds of indexed annuity products, thousands of index annuity strategies, and that “the selection of the crediting index or indices is an important and often complex decision.” Further, there are several methods for determining changes in the index, with different methods resulting in varying rates of return. Rates of return are also affected by “participation rates, cap rates, and the rules regarding interest compounding.” Because “insurers generally reserve rights to change participation rates, interest caps, and fees,” FIAs can “effectively transfer investment risks from insurers to investors.” The DOL found that FIAs may offer guaranteed living benefits, but such benefits “may come at an extra cost and, because of their variability and complexity, may not be fully understood by the consumer.” The DOL also cited the SEC, which recently stated, “[y]ou can lose money buying an indexed annuity … even with a specified minimum value from the insurance company, it can take several years for an investment in an indexed annuity to break even.”32
The DOL comprehensively assessed existing securities regulation for variable annuities, state insurance regulation of all annuities, academic research, government and industry statistics on the IRA marketplace, and consulted with numerous government and industry officials, including the National Association of Insurance Commissioners (“NAIC”), SEC, FINRA, the Department of the Treasury, the Consumer Financial Protection Bureau, the Council of Economic Advisers, and the National Economic Council. The DOL found the protections prior to the current rulemaking insufficient to protect investors.33
The DOL found the annuity market to be influenced by contingent commissions, which “align the insurance agent or broker’s incentive with the insurance company, not the consumer,” that existing protections do not “limit or mitigate potentially harmful adviser conflicts,” and that “notwithstanding existing [regulatory] protections, there is convincing evidence that advice conflicts are inflicting losses on IRA investors.” The DOL found the conflicts would cost investors “at least tens and probably hundreds of billions of dollars over the next 10 years … despite existing consumer protections,” and that “the material market changes in the marketplace since 1975 have rendered [prior regulation] obsolete and ineffective.”34
In particular, today’s marketplace [commissions] … give[ ] … advisers a strong reason, conscious or unconscious, to favor investments that provide them greater compensation rather than those that may be most appropriate for the participants … an ERISA plan investor who rolls her retirement savings into an IRA could lose 6 to 12 and possibly as much as 23 percent of the value of her savings over 30 years of retirement by accepting advice from a conflicted financial adviser.”35
The DOL also found that state insurance laws and their enforcement vary significantly because only thirty-five states have adopted the NAIC model regulation, producing inconsistent protections and confusion for consumers. The U.S. Department of the Treasury noted that the absence of a national standard is problematic because there are unprecedented numbers of retirement investors, and financial professionals are selling increasingly complex products, therefore more uniform regulation is necessary to protect investors.36
The DOL determined the new rules would work with and complement state insurance regulations.37
Judge Lynn summarized the current environment and the need and appropriateness of the Rule by stating that
The extensive changes in the retirement plan landscape and the associated investment market in recent decades undermine the continued adequacy of the original approach in PTE 84–24. In the years since the exemption was originally granted in 1977, the growth of 401(k) plans and IRAs has increasingly placed responsibility for critical investment decisions on individual investors rather than professional plan asset managers. Moreover, at the same time as individual investors have increasingly become responsible for managing their own investments, the complexity of investment products and range of conflicted compensation structures have likewise increased. As a result, it is appropriate to revisit and revise the exemption to better reflect the realities of the current marketplace.38
So, going back and evaluating whether the Court sastisfied the APA’s requirement with regard to their decision to stay the Rule, one could justifiably argue that the Fifth Circuit seemingly just announced that the industry would prevail, arguably on a bootstrapped argument based largely on the court’s unquestioned acceptance of the annuity industry’s unproven allegations, with no indication that the court even considered the DOL’s statement that FIAs cause an annual loss of $17 billion anually.
Furthermore, unlike with Judge Lynn’s opinion, the Fifth Circuit’s opinion provides there no evidence that the Fifth Circuit factored in the inherent structural problems of FIAs and VAs, including the fact the fact that FIAs typically retain the right to unilaterally change the various terms that affect a FIA owner’s realized return. In short, no discussion of the the process that the Fifth Circuit used to balance the interest and determine that movant’s interest were more important. the conspicuous lack of any such numerical injuries in connection with particpants wonders how meaningful and balanced the consideration of such matters was, especially given the ease with which the annuity industry can impose conditions and restrictions that result in reducing a FIA investor’s realized return by 20 percent or more per year.
And yet, the Fifth Circuit’s decision to stay the Rule and prevent implementation of the Rule condones such financially harmful inequitable practices. In analyzing the Fifth Circuit’s decision to stay the effectiveness of the Rule, I have offered the analogy of a hit-and-run driver. The Fifth Circuit’s arguments willfully ignore the potential and permanent harm inflicted by just one imprudent “hit-and-run” annuity transaction.
The Court seemingly based it’s conclusion that the annuity advocates would prevail on the merits based on (1) numerous large alleged damages that the annuity industry would sustain as a result of the rule, and (2) the Court’s allegation that the Rule was otherwise inconsistent with ERISA. As for the alleged damages, the annuity advocates suggested that the alleged costs could threaten the existence of the annuity industry. 39 (5th @10). Specific projected losses included more than half a billion dollars in compliance costs, another $2.5 billion in costs over the next decade. The Court quickly responded that even the DOL’s projected costs was sufficient to establish irreparable injury.
Interestingly, the Court never mentioned the fact that the DOL referenced annual losses of $17 billion annually due to fixed indexed annuities (FIAs), or the fact that the annuity advocates numbers were purely speculative since they involved future projections.
I would caution the Court against unquestioningly accepting the annuity advocate’s damages estimates. I would remind the Court of the annuity industry’s intentional misleading of the courts in connection with the industry’s efforts to convince courts to require annuities and structured settlements in cases involving significant damages, with the industry promoting a “squandering plaintiff” ruse. In support of their campaign, they claimed to have studies showing that 95 percent of plaintiffs receiving lump sum settlements dissipated the settlement proceeds within five years.
Jeremy Babener, a well-known and respected settlement expert, exposed the “squandering plaintiff” ruse in a legal article, finding that
Although widely cited to justify the tax favored treatment of structured settlements, the statistical data relied upon [in arguing the “squandering plaintiff] is an oft-repeated urban myth of unsubstantiated origin. The statistical data does not, in fact exist….[From] a policy standpoint, the fundamental im0portance of the subsidy demands more than anecdotal evidence. A policy that impacts millions of [people] is deserving of a substantial empirical foundation.40
Babener also noted that when one industry general counsel was questioned about evidence behind the “squandering plaintiff” argument, the attorney admitted that he believed that much of the dissipating claimant argument was “imagined.”41
Fortunately, the courts eventually saw through the “squandering plaintiff” ruse. As a result, the courts now generally require the annuity industry to supply documentation to the court indicating what the actual costs the insurer will incur in purchasing a proposed annuity. The injured plaintiff generally also has the option to request the court to establish a so-called “qualified settlement fund (QSF), which allows the plaintiff to receive settlement funds and look for a fair annuity. without being subject to immediate taxation on such settlement funds.
As a plaintiff’s attorney, the damage caused by the annuity industry in promoting the “squandering plaintiff” ruse is indelibly lodged in my mind, as it effectively resulted in the annuity industry “victimizing the victims,” the annuity industry’s unethical acts and conscious disregard for people who had suffered life changing injuries and could least afford the harm resulting from the ruse perpetrated by the annuity industry. Hopefully, as this case progresses throught the legal system, future courts will consider the “hit-and-run” analogy and protect plan participants in reviewing the applicable evidence and by upholding the Rule in connection with every single transaction covered under the Rule.
Two quotes that seem relevant in connection with the Retirement Security Rule litigation are:
Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence. – President John Adams
The truth is, we always know the right thing to do. The hard part is doing it. – General Norman Schwartzko
Going back to the 2 percent spread on a FIA capped at an annual return of 10 return, resulting in a 20 percent in the FIA owner’s realized return, this is exactly the type of inequitable “hit-and-run” conduct that the Fifth Circuit’s decision to stay the Rule effectively condones. One can only assume that the Fifth Circuit did not understand the math involved, as its hard to beleive that any court would knowingly approve of such inequitable results and the resulting financial harm created on retirees.
Both Chief Judge Stewart and Chief Judge seemingly felt the same way in arguing that the DOL Rule was a permissible and necessary exercise of power by the DOL. Once again, as Chief Judge Stewart acknowledged the impact of change over time and the need for regulations to change proactively and appropriately in order to protect plan participants:
Despite the relevant context of time and evolving marketplace events, Appellants and the panel majority skew valid agency action that demonstrates an expansive-but-permissible shift in DOL policy as falling outside the statutory bounds of regulatory authority set by Congress in ERISA and the Code. Notwithstanding their qualms with these regulatory changes and the effect the DOL’s exercise of its regulatory authority might have on certain sectors of the financial services industry, the DOL’s exercise was nonetheless lawful and consistent with the Congressional directive to “prescribe such regulations as [the DOL] finds necessary or appropriate to carry out [ERISA’s provisions].” 42
Chief Judge Lynn’s expressed similar sentiments
the DOL may “prescribe such regulations as [it] finds necessary or appropriate to carry out the provisions of [ERISA],” and to “define [the] accounting, technical and trade terms used in [ERISA].”43
ERISA was enacted on the premise that the then-existing disclosure requirements did not adequately protect retirement investors, and that more stringent standards of conduct were necessary. Although ERISA includes disclosure requirements, it also imposes “standards of conduct, responsibility, and obligation[s]” for fiduciaries. The DOL’s new rules comport with Congress’ expressed intent in enacting ERISA. As a result of as the rulemaking process, the DOL rejected a disclosure-only regime, finding that disclosure was ineffective to mitigate the problems ERISA sought to remedy.44
Chamber of Commerce of the U.S. v. Hugler, 231 F. Supp. 3d 152, 175 (N.D. Tex. 2017)
The DOL enacted the Rule because it justifiably found that there was no meaningful oversight of FIAs, resulting in an annual loss of approximately $17 billion a year, with no sign that the state insurance commissioners and/or the NAIC were going to do anything to address the problem to protect plan participants. History definitely supports the DOL’s conclusions, given the laissez faire approach to compliance and enforcement of most state insurance commissioners.
Judge Lynn provided a detailed and excellent analysis of this issue
The DOL described the complexity of FIAs in its Regulatory Impact Analysis (“RIA”). The RIA explained that FIAs generally provide “crediting for interest based on changes in a market index,” but noted there are hundreds of indexed annuity products, thousands of index annuity strategies, and that “the selection of the crediting index or indices is an important and often complex decision.” Further, there are several methods for determining changes in the index, with different methods resulting in varying rates of return. Rates of return are also affected by “participation rates, cap rates, and the rules regarding interest compounding.” Because “insurers generally reserve rights to change participation rates, interest caps, and fees,” FIAs can “effectively transfer investment risks from insurers to investors.” The DOL found that FIAs may offer guaranteed living benefits, but such benefits “may come at an extra cost and, because of their variability and complexity, may not be fully understood by the consumer.” The DOL also cited the SEC, which recently stated, “[y]ou can lose money buying an indexed annuity … even with a specified minimum value from the insurance company, it can take several years for an investment in an indexed annuity to break even.45
The evidence clearly shows that the Fifth Circuit’s allegations that the the DOL acted “arbitrarily and capriciously” simply have no merit. The DOL explained how FIA sales can generate conflicts of interest, and that with increased sales of FIAs there have been additional complaints that the products were sold to customers who did not need them. The DOL noted a perceived relationship between increased sales of FIAs and unusually high commissions, which are typically higher than for fixed rate annuities. The DOL also noted that FINRA and the SEC concluded that FIAs are riskier than fixed rate annuities, citing FINRA’s conclusion that FIAs “are anything but easy to understand” and “give you more risk (but more potential return) than [a fixed rate annuity].”46
The DOL found the annuity market to be influenced by contingent commissions, which “align the insurance agent or broker’s incentive with the insurance company, not the consumer,” that existing protections do not “limit or mitigate potentially harmful adviser conflicts,” and that “notwithstanding existing [regulatory] protections, there is convincing evidence that advice conflicts are inflicting losses on IRA investors.” The DOL found the conflicts would cost investors “at least tens and probably hundreds of billions of dollars over the next 10 years … despite existing consumer protections,” and that “the material market changes in the marketplace since 1975 have rendered [prior regulation] obsolete and ineffective.”47
[T]oday’s marketplace [commissions] … give[ ] … advisers a strong reason, conscious or unconscious, to favor investments that provide them greater compensation rather than those that may be most appropriate for the participants … an ERISA plan investor who rolls her retirement savings into an IRA could lose 6 to 12 and possibly as much as 23 percent of the value of her savings over 30 years of retirement by accepting advice from a conflicted financial adviser.”48
The DOL also found that state insurance laws and their enforcement vary significantly because only thirty-five states have adopted the NAIC model regulation, producing inconsistent protections and confusion for consumers. The U.S. Department of the Treasury noted that the absence of a national standard is problematic because there are unprecedented numbers of retirement investors, and financial professionals are selling increasingly complex products, therefore more uniform regulation is necessary to protect investors.49
Judge Lynn then noted that with all these considerations in mind, the DOL properly explained their reasoning:
The extensive changes in the retirement plan landscape and the associated investment market in recent decades undermine the continued adequacy of the original approach in PTE 84–24. In the years since the exemption was originally granted in 1977, the growth of 401(k) plans and IRAs has increasingly placed responsibility for critical investment decisions on individual investors rather than professional plan asset managers. Moreover, at the same time as individual investors have increasingly become responsible for managing their own investments, the complexity of investment products and range of conflicted compensation structures have likewise increased. As a result, it is appropriate to revisit and revise the exemption to better reflect the realities of the current marketplace. 50
Chamber of Commerce of the U.S. v. Hugler, 231 F. Supp. 3d 152, 190-91
cChamber of Commerce of the U.S. v. Hugler, 231 F. Supp. 3d 152, 190-91 (N.D. Tex. 2017)
While not going into such valuable detail, Chief Judge Stewart expressed a similar rationale for upholding the Rule
Notwithstanding the DOL’s reasoned explanation for the new regulations, the panel majority maintains that the DOL acted unreasonably and arbitrarily when it promulgated the new fiduciary rule and, in a strained attempt to justify this conclusion, the panel majority disregards the requirement of showing judicial deference under Chevron by highlighting purported issues with other provisions of the regulation. Each of the panel majority’s positions fails for reasons more fully explained below.51
In light of changes in the retirement investment advice market since 1975,…, the DOL reasonably concluded that limiting fiduciary status to those who render investment advice to a plan or an IRA “on a regualr basis” risked leaving retirement investors inadequately protected. This is especailly so given that “one-time transactions like rollovers will involve trillions of dollars over the next five years and can be among the most significant financial decisions investors will ever make.52
The panel majority’s conclusion that the DOL exceeded its regulatory authority by implementing the regulatory package that included a new definition of investment-advice fiduciary and both modified and created new exemptions to prohibited transactions is premised on an erroneous interpretation of the grant of authority given by Congress under ERISA and the Code. I would hold that the DOL acted well within its regulatory authority—as outlined by ERISA and the Code—in expanding the regulatory definition of investment-advice fiduciary to the limits contemplated by the statute, and would uphold the DOL’s implementation of the new rules.54
When people ask me explain the case as simply as possible, my answer is that the annuity industry knows that it can never satisfy a true fiduciary standard that requires the industry to put the public’s “best interest” first, as its products and services are designed to maximize their profit to the detriment of plan participants and other investors. The annuity industry is well aware of these issues, thus the constant oppositon to a true fiduciary standard.
I do wonder if embracing the fiduciary standard and making some changes in annuity products might not acually open more, and profitable, markets for the annuity industry and increase profits. Some of my colleagues within the annuity industry have expressed similar thoughts.
Going forward , two of my favorite quotes come to mind, one from John Adams, the other from the late Genreral Norman Schartzkopf:
Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence. – John Adams
The truth is, we always know the right thing to do. The hard part is doing it. – General Norman Schwartzkopf
Stay tuned!
PostScript Late Friday it was announced that the DOJ would appeal both of the district court decisions vacating the Rule. There also reports that the parties were talking, hopefully about a resolution to the litigation. Hopefully, these reports are true. As well-known ERISA attorney, Bonnie Treichel, recently observed.
Arguably the most impacted parties then are the investors these individuals serve that aren’t provided service as an ERISA fiduciary.55
Bradley Campbell of Faegre Drinker recently commented on the unusual strength of the language in the Fifth Circuit’s “Memorandum Opinion and Order” staying the DOL’s Retirement Security Rule.1 Given distristrict court Chief Judge Lynn’s earlier well-reasoned analysis and opinion in connection with the DOL’s initial Fiduciary Rule,2 as well as the fact that the Fifth Circuit’s Chief Judge cited the district court’s decision in his dissenting opinion in the 5th Circuit’s decision on the Rule,3 the Fifth’s Circuit’s statement that “[p]laintiffs are virtually certain to succeed on the merits,”4 arguably raises some legitimate questions, especially if, as expected, this case moves forward to SCOTUS..
As the court stated, in order to grant a stay or a preliminary injunction or stay, the movant must show (1) a substantial likelihood of success on the merits; (2) a substantial threat of irreparable harm; (3) that the balance of hardships weights in the movant’s favor; and (4) that issuance of a preliminary injunction will not disserve the public interest.5
As to the likelihood of success, I would point to the Judge Lynn’s well-reasoned district court decision, one which was persuasive enough to convince the Chief Judge of the Fifth Circuit’s to dissent from the majority’s decision. The Fifth Circuit stated that the DOL’s Rule was “arbitrary and capricious.”10 The Court also stated that it had weighed the equities between the parties. And yet, I would respectfully submit that common sense and “humble arithmetic” suggest otherwise.
Annuity advocates often argue that the DOL’s proposed Rule is unnecessary, that the NAIC oversees the insurance industry to ensure that the public’s “best interests” are protected, that conflicts of interest are properly addressed. However, as the Retirement Security Rule points out
[The NAIC’s] definition of ‘material conflict of interest] expressly carves out ‘cash compensation or non-cash compensation’ from treatment as sources of conflicts of interests. The NAIC model Regulation also provids that it does not apply to transactions involving contracts used to fund an employee pension or welfare plan covered by ERISA.6
The NAIC expressly disclaimed that its standard creates fiduciary obligations, and the obligations differ in significant respects from those applicable to broker-dealers in the SEC’s Regulation Best Interest..[The NAIC’s model] does not expessly incorporate the obligation not to put the producer’s or insurer’s interests before the customer’s interests, even though compliance with their terms is treated as meeting the ‘best interest’ standard.7
Additionally, the obligation to comply with the ‘best interest’ standard is limited to the indivual producer, as opposed to the insurer repsonsible for supervising the producer.8
Judge Lynn then provides support for the need for the DOL’s Retirement Security Rule by pointing out that
Further, the SEC’s Regulation Best Interest and the NAIC Model Regulations are each limited in important ways in terms of application to advice provided to ERISA plan fiduciaries although this is not the case with the Advisers Act fiducirry obligations….The NAIC Model Regulation does not apply to transactions involving conracts used to fund an employee pension or welfare plan covered by ERISA. The Department [of Labor] believes that retirement investors and the regulated community are best served by an ERIAS fiducairy standard that applies uniformly to all invstments that retirement investors may make with respect to their retirement accounts.9
And yet, the Fifth Circuit ignored the DOL’s accurate and logical arguments and analysis, choosing to protect the annuity industry over protecting plans and plan participants by issuing a stay of the DOL Rule based upon the Court’s opinion that the industry is virtually certain to succeed on the merits. It could legitimately be argued that Judge Lynn’s opinion more accurately reflects the current situations and concerns that caused the DOL to create the Retirement Security Rule in the first place..
One of the key targets of the Rule was fixed indexed annuities (FIAs). FIAs were origianlly marketed as equity indexed annuities (EIAs). I was a compliance director at the time EIAs were introduced. My immediate response when the annuity wholesaler introduced then during a weekly sales meeting was “no way,” as the product was misleading in suggesting market returns. However, the various artificial restrictions on returns made it clear that the product was structured more to ensure that the annuity issuer benefitted at the annuity owner’s expense.
My opinion on FIAs/EIAs remains the same. And apparently others in the industry agreed with my assessment, since many of the larger insurance companies avoided the product due to potential liability concerns when the EIAs were first introduced.
A vice president at Northwestenn Mutual stated that
These products are so complicated that I think it’s a stretch to believe that the agents, much less the clients, understand what they’ve got. The commissions are extreme. The surrender eriods are too long. The complexity is way too high.11
MassMutual Financial Group was so concerned that they prepared a study compaing how an FIA based on the S&P 500 would have performed over the 30-year period ending Dececmber 2003. The study concluded that the EIA would have delivered just 5.8% a year, compared to the 8.5% return on the S&P 500 (without dividends) and 12.2% return (with dividends reinvested). The study also found that investors in the EIA would have even done better invested in simple Treasury bills, which delivered 6.4% a year.12
In ” Can Annuities Offer Competitive Returns?,13“Dr. William Reichenstein, formerly a chaired professor of finance at Baylor University, came to the same conclusion about the imprudence of EIAs
By design, indexed annuities cannot add value. By design, (1) they do not attempt market timing, (2) they do not make sector/industry/style/size bets, and (3) they do not try to add value through security selection….So, I concluded that the risk-adjusted returns on indexed annities must trail the risk-adjusted returns available in marketable securities by the sum of their spread plus their transaction costs,14
Annuity issuers adamantly oppose disclosing the spreads that they assess against annuity owners. Spreads reduce the amount of interest credited to the annuity owner. Even when annuity disclose alleged spreads, they may not accurately reflect the actual impact in terms of reduced returns/loss incurred by an annuity owner. The graphic shown below shows how an alleged annual 2 percent spread (200 basis point) in connection with an FIA with a 10 percent cap effectively reduces an annuity owner’s annual return by 20 percent, not by the alleged 2 percent. And this does not even factor in the annual compounding effect of this excessive cost.
It is hard to believe that any court could/would try to ignore or justify such an inequitable practice, one which reduces an investor’s annual return by an outrageous 20 percent or more a year. Despite the Fifth Circuit’s “arbitrary and capricious “ allegation, these are facts based on ‘humble arithmetic,” not self-serving, speculative projections and “declarations”.
Yet, in staying the effectiveness of the DOL’s Rule, that is exactly what the Fifth Circuit has effectively done by virtue of issuing a stay of the Rule and allowing the annuity industry to continue to market these anti-consumer best interest products for who knows how long, with serious consequences for workers trying the prepare for “retirement readiness,” workers who may not have the time to make up for unnecessary losses resulting from the stay.
The Fifth Circuit also tried to justify the stay based on the annuity industry’s allegations of irreparable harm. The first words that came to mind when I read this was the “squandering plaintiff” ruse that the annuity industry used to try to convince the courts to require that structured settlements be required in actions involving significant damages. The annuity advocates claimed that the annuity industry had data and studies showing that 90 percent of injured plaintiffs receiving lump sum settlements instead of structured settlements and annuities dissipated such settlements within five years. And yet, when called on to produce such data studies, the annuity industry failed to do so.15
Jeremy Babener, a settlement expert, wrote several informative articles on this issue. Eventually, he cited an annuity advocate and industry in-house legal counsel who suggested that no such studies or findings ever existed, that they were simply made up/imaginary.16
So, against that backdrop of the annuity industry’s willingness and propensity to exaggerate and misrepresent the truth when it serves their purpose, I have to wonder to what extent the Fifth Circuit properly weighed the industry’s alleged irreparable claims, especially given the Court’s note that the alleged injury must also be complete, that “speculative injury is not sufficient.”17
Among the industry’s claims, based on personal self-serving “declarations”
(1) the Rule will cause more than half a billion dollars in compliance costs, and another $2.5 billion in costs over the next decade. Compliance costs are always in flux as new products are introduced. And yet, by their very nature, such forward looking projections are self-serving and speculative, and, thus, should not be a factor in any decision since they would be inadmissable under the federal rules of evidence;18
(2) 87% of independent insurance agents “estimate” that the Rule will increase their staffing and operational costs,19
(3) 93% of these independent agents anticipate rising professional liability insurance premiums,20
(4) Some agents fear they will be forced out of business, forced to restructure their business, or to retire. (speculative and hyperbole).21
Compliance costs are always a cost in both the securities and insurance industries. However, I remain sceptical of such claims given my compliance background. If one accepts these claims at face value, I would argue that it is tantamount to an admission against interest, an admission that an insurance/annuity company is selling these products without proper compliance programs and safeguards. These “woe is me” claims are reminiscent of the Aesop’s famous saying _ “A tyrant always has a pretext for his tyranny.”
These self-serving “declarations” should have absolutely no weight in whether to protect workers against imprudent investment products. Instead, the evidence suggests that once again the legal system is once again drinking the annuity industry’s self-serving misrepresentation Kool-aid without verification of same, just as with the industry’s “squandering plaintiff” ruse in connection with structured settlements and significant injuries, all to once again benefit the annuity industry at the public’s expense.
The insurance/annuity industry created and market these complex and misleading products to ensure that they profit at the public’s expense. They should now be tasked with cleaning up their own mess to ensure that their products are actually in the best interest of consumers, especially those saving for retirement.
I think that most people agree that this case will, and should, be heard by SCOTUS to ensure an equitable and consistent interpretation and enforcement of the rights and guarantees promised under ERISA. As for now, the courts need to “call” the annuity industry’s bluff in order to properly weight the equities and to preserve, protect and promote ERISA’s stated purpose and goals. The DOL should also petition for a reconsideration of the stay by the Fifth Circuit, en banc, and then petition SCOTUS, if necessary.
For more information on the inherent fiduciary liability issues with FIAs, variable annuities, and annuities in general, see my earlier post, “A Fiduciary’s Guide to Annuities: Why Go There?
Notes 1. American Council of Life Insurers v. United States Department of Labor, “Memorandum Opinion and Order,” Civil Action No. $:24-cv-00482-O 7-26-2024. (Memorandum) 2. Chamber of Commerce of the United States of America v. United States Department of Labor, 231 F. Supp.3d 152 (N.D. Tex 2017). (District Court) 3. Memorandum, 7. 4. Memorandum, 7.. 5. Memorandum, 7. 6. 29 CFR Part 2510.B.5 (Retirement Security Rule), State Legislative and Regulatory Developments 7. Retirement Security Rule, 100. 8. Retirement Security Rule, 101. 9. Retirement Security Rule, 101. 10. Memorandum, 7. 11. “Why Big Insurers Are Staying Away From This Year’s Hot Investment Product,” Wall Street Journal, D-12, December 14, 2005. (Staying Away) 12. Staying Away, D-1. 13. William Reichenstein, “Can Annuties Offer Competitive Returns?” Journal of Financial Planning, (August 2011), 36; William Reichenstein, “Financial Analysis of Equity-Indexed Annities,” Financial Services Review 18, 291-311. 14. Reichenstein, 36 15. Jeremy Babener, “Justifying the Structured Settlement Tax Subsidy: The Use of Lump Sum Settlement Monies,” NYU Journal of Law and Business Vol 6 (Fall 2009), 129. (Babener) 16. Babener. 129. 17. Memorandum, 10. 18. Memorandum, 11. 19. Memorandum, 11-12 20.. Memorandum, 11-12. 21. Memorandum, 12.
I recently posted my initial impressions on the 11th Circuit’s Decision in the Pizarro v. Home Depot 401(k) case:
It should be noted that the court granted HD summary judgment even though the court found that there were significant issues of material facts, which typically precludes summary judgment under Rule 56 of the federal rules of civil procedure. Hopefully, SCOTUS will have an opportunity to weigh in in order to resolve the split within the courts to ensure all employees’ rights guaranteed under ERISA are protected by the uniform and equitable interpretation and enforcement of ERISA in the courts, The 11th Circuit’s decision is also contra to the amicus brief filed by the Solicitor General with SCOTUS in the Brotherston case, hashtag#401k #hashtag #fiduciaryprudence
Having gone back and reviewed the district court’s original decision, the 11th Circuit’s decision and the the amicus brief that the DOL filed, I would like to share these additional observations and opinions, as this case will shape the future of both ERISA and ERISA litigation, and thus the rights and protections gauranteed to American workers.
Right now, ERISA can fairly be defined by the well-known acronym SNAFU due to the inconsistent interpretation and enforcment of ERISA within the federal courts. The courts are split on the issue as to which party has the burden of proof with regard to causation of damages in ERISA actions.
While there is currently a split within the federal courts, the majorituy of the courts adhere to the principle that plan sponsors have the burden of proof on causation, based on the basic principles set out in the common law of trusts. In Tibble v. Edison International,1 the Supreme Court (SCOTUS) endorsed the Restatement (Third) of Trusts (Restatement) as a legitimate resource in resolving trust and fiduciary disputes.
The Restatement’s position is generally that once plan participants show a fiduciary breach and resultinng loss, the burden of proof on the issue of causation shifts to the plan sponsor. This is different than the general rule in civil litigation, where the plaintiff is responsibleible for proving all aspects of his/her case. As the Solicitor General explained in an amicus brief filed with SCOTUS in the Putnam Investments, LLC v. Brotherston case, the change in ERISA litigation is due largely to the fact that plan sponsors often have access to relevant information, such as the rationale behind the internal plan decisions about why certain investment options were selected, that is known only to them.
When plan participants file an ERISA action against a plan sponsor, the plan sponsor typically responds quickly by filing a motion to dismiss and or a motion for summary judgment to quickly resolve the case and prevent discovery by the plan participants. This strategy creates a fundamental fairness/equity issue, as it may prevent the plan participants to obtain the critical information needed to prove their case, the information uniquely known only to the plan sposnsor.
The Solicitor General has addressed the current situation regarding shifting the burden of proof, stating that
In trust law, burden shifting rests on the view that ‘as between innocent beneficiaries and a defaulting fiduciary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty. ERISA likewise seeks to ‘protect *** the interests of participants in employee benefit plans’ by imposing high standards of conduct on plan fiduciaries. Indeed, in some circumstances, ERISA reflects congressional intent to provide more protections than trust law. Applying trust law’s burden-shifting framework, which can serve to deter ERISA fiduciaries from engaging in wrongful conduct, thus advances ERISA’s protective purposes.3
More importantly, we have many decades of experience with the allocation of the burden of proof called for routinely by trust law, with no evidence of any particular difficulties, unfairness, or costs in applying that rule in the few cases in which it actually makes a difference.4 Solicitor General’s Brotherston amicus brief , 10 (Amicus brief) and 907 F.3d 39
The Sixth Circuit Court of Appeals recently acknowledged the equity issues in the current situation, stating
But at the pleading stage, it is too early to make these judgment calls. ‘In the absence of further development of the facts, we have no basis for crediting one set of reasonable inferences over the other. Because either assessment is plausible, the Rules of Civil Procedure entitle [the three employees] to pursue [their imprudence] claim (at least with respect to this theory) to the next stage….5
This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth ‘investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares’ because ‘the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….’ Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.6
In support of awarding Home Depot a summary judgment, both the district court and the 11th Circuit cited previous 11th Circuit decisions as controlling. However, as the DOL’s amicus brief pointed out, the cited cases do not support the argument against shifting the burden of proof on the issue of causation, but rather the decisions cited actually support the argument for shifting the burden of proof on causation.
As the DOL pointed out,
The district court’s error infected its disposition of nearly every strand of Plaintiff’s claim.7
Willett did not even consider burden shifting, let alone reject it. If anything, the Eleventh Circuit precedent – including Willett itself – supports applying trust law’s burden shifting rule to ERISA fiduciary cases.8
However, the 11th Circuit’s decision not t o shift the burden on the issue of causation is questionable for more than just its reliance on its Willett decision. The 11th Circuit rejected prior rulings citing the informational edge held by plan sponsors. As the Supreme Court ruled in the Schaffer decision
the ordinary rule does not place the burden upon a litigant of establishing facts peculiarly within the knowledge of his adversary.9
This approach is aligned with the Supreme Court’s instruction to “look to the law of trusts ” for guidance in ERISA cases.10 Tibble The 11th Circuit’s decision is contrary to ERISA’s trust law roots , the weight of circuit authorty, and the 11th Circuit’s case law. amicus
In rejecting Plaintiff’s burden shifting argument, the 11th Circuit denied the existince of an “informational advantage” in favor of plan sponsors, stating that
ERISA imposes on fiduciaries a comprehensive scheme of mandatory disclosure and reporting, both to plan particiapnts and to the public at large. The statute itself thus enforces a suite of requirements mitigating the informational advantage imputed to the trustee at common law. These disclosures, combined with the ‘proper use of discovery tools,” men that ERISA fiduciaries lack the informational advanatge that would justify shifting the burden.11
I would argue that the Court’s argument is misleading. Furthemore, the facts in this case itself, and Home Depot itself , nullify the Court’s argument.
First, the disclosures required by ERISA, are primarily quantitative in nature, e.g., returns, and do not address the qualitative/fiduciary prudence aspects of a plan’s deliberative process.
In the immediate case, the very lack of meaningful minutes of the plans deliberative meetings deny the plan participants the information needed to properly prove their case, resulting in the very “informational advantage that the plan said would be needed to justify shifting the burden of proof.
The district noted the qualitative problems with the plan’s minutes, including (1) the lack of an explanation on why the court failed to remove a fund whose trailing three-year performance had underpermed its benchmark for fourteen consecutive quarters, and its five-year performance had underperformed its benchmark for ten consecutive quarters, yet removed another fund when it lagged its benchmark for only one quarter;
(2) The fact that the investment committee did not benchmark to the benchmarks specified in the plans investment policy statement (IPS), and in some cases relied on customized benchmarks, which are always suspect due to the potenial for self-serving manipulation. Failure to follow a plan’s IPS is evidence of a fiduciary breach that a plan did not engage in a prudent monitoring process;
(3) The minutes consistently failing to disclose the amount of time spent deliberating and the content of such discussions.
(4) the evidence indcates that Home Depot “neither invetigated nor discussed whether advisory fees of certain advisors were “reasonable relative to the service they provided, even thought the evidence clearly indicated that such fees were higher than rates offered by competitors for active account management. The evidence showed that the plan’s fees were also higher than those charged by competitors to comparably-sized plans.12
(5) Home Depot measured some funds against changing benchmarks, the rationale for which was never discussed in the Investment Committee meeting minutes.13
(6) The Investment Committee did not discuss the fact that the TS&W Fund, As of March 2017, had underperformed 99% of its peers on a three-year basis and 83% of its peers on a five-year basis.14 * 27
(7) The Inveastment Committee measured the Blackrock TDFs using a BlackRock custom benchmark, in violation of the terms of the IPS. The BlackRock TDFs underperformed from 2013-2015.15
The Home Depot’s response is both evidence of the plan’s attitude toward its fiduciary responsibilities and the fallacy in the the 7th Circuit’s “no informational advantage” theory:
Minutes are not verbatim transcripts of everything discussed at IC (investment committee) meetings so this evidence does not raise a material fact question about the prudence of their monitoring process.16 District Court @218
The district court obviously disagreed, ruling that the lack of information and explanation within Home Depot’s minutes did create a material fact questions. Under Rule 56, that alone should have precluded summary judgment in favor of Home Depot. Yet, the district court did grant Home Depot’s motion for summary judgments and the 11th Circuit has now upheld such action,
Home Depot’s nondisclosure position creates the “guessing” situation that the 1st Circuit warned against in their Brotherston decision:
It makes liittle sense to have the plaintiff hazard a guess as to what the fiduciary would have done had it not breached its duty in selecting investment vehicles, only to be told “guess again.”17 Brother @ 39
Using the 11th Circuit’s own announced standard, the 11th Circuit’s failure to shift the burden of proof on causation should be reviewed by SCOTUS. The ongoing refusal of some federal courts to adopt the majority position of shifting the burden of proof on causation is unjustifiable and continues to deprive a signficant portion of workers the protections and rights guaranteed to them under ERISA, simply due to the jurisdictions they live in.
The Solicitor General of the United States has already weighed in on this issues by virtue of the amicus brief it filed in connection with the Brotherston. While the Solicitor General ultimately recommended that the Court not grant certiorari in the case, his opinion was basednot on the merits, but on the fact that it was an interlocutory appeal from an ongoing case. Based on the merits of the case, he supported the shifting the burden of proof argument based on the principles established by the Restatement of Trusts and the Supreme Court’s support of the Restatement in resolving fiduciary issues.
ERISA is a comprehensive statute designed to promote the interests of employees and their beneficiaries. The statute promotes this interest by, among other things, imposing stringent trust law-derived duties on those who manage the plan and its assets.18 DOL amicus @1,
However, the current split between the federal courts on the issue of the burden of proof on causation has resulted in inconsistent and inequitable decisions, causing investors to suffer unnecessary financial loss over the six years since the Court denied certiorari in Brotherston. Hopefully, the plaintiffs in this case will appeal for certiorari so that SCOTUS has an opportuntity to establish a uniform standard on this issue in order to resolve the inconsistent interpresentation and enforcement of ERISA.
Notes 1. Tibble v. Edison Int’l, 575 U.S. 523 (2015) 2. Amicus Brief of the Solicitor Genral of the United States, Putnam Investments, LLC v. Brotherston, at 19. (Solicitor’s Brief) 3. Solicitor’s Brief, at 17. 4. Solicitor’s Brief, at 17 and Brotherston v. Putnam Invesments, LLC., 907 F.3d 17, 39 (1st Cir. . 5. Foreman v. TriHealth, Inc, 40 F.4th 443, 450 (6th Cir. 2022) (TriHealth) 6. TriHealth, 453. 7. DOL Amicus Brief in Pizarro v. Home Depot, at 24. (DOL brief) 8, Ibid., at 19, Useden v. Acker, 947 F.2d 1563 (11th Cir. 1991), Willett v. Blue Cross and Blue Shield of Alabama, 953 F.2d 1335 (11th Cir. 1992). 9. Schaffer v. Weast, 546 U.S. 49, 60. 10. Tibble v. Edison Int’l, 575 U.S. 523, 529 (2015). 11.Pizarro v. Home Depot, Inc., Case No. 22-13643 (11th Circuit 2024) 12. DOL Brief, at 4, 5, 8 13. Pizarro v. Home Depot, Inc.,2022 WL 4687096, at *7, *8,*16 and *21-22. (N.D. Ga. 14. DOL brief, 27 15. Pizarro v. Home Depot, 2022 WL 46709687096, at *8, *21-22. 16. Pizarro v. Home Depot, 2022 WL 46709687096, at *7, *8,*16 and *21-22. 17. Brotherston, 39 18. DOL brief, 1
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 11th Circuit recently released its much anticipated decision in Pizarro v. Home Depot. The case is significant since it involves the question of which party has the burden of proof on the issue of causation in ERISA litigation. There is currently a split within the federal circuit courts on this issue, resulting in an inconsistent and inequitable interpretation and enforcement of ERISA, which has resulted in plan participants effectively being denied the rights and protections guaranteed to them under ERISA.
The Court’s decision presented a number of interesting and novel arguments, not the least of which was the court’s rejection of a common argument in these cases, the argument that the burden of proof on causation by necessity must belong to a plan sponsor given the fact that they alone know what policies and procedures were used in evaluating and selecting the plan’s investment options.
The 11th Circuit disputed that assumption:
ERISA imposes on fiduciaries a comprehensive scheme of mandatory disclosure and reporting, both to plan participants and to the public at large. The statute itself thus enforce a suite of requirements mitigating the informational advantage imputed to the trustee at common law. These disclosures, combined with the “proper use of discovery tools,” mean that ERISA fiduciaries lack the informational advantage that would justify shifting the burden of proof.
The 11th Circuit is surely aware that plan sponsors usually file motions to dismiss and/or Summary judgment motions quickly to prevent the type of meaningful discovery contemplated by the Court. In response to the 11th Circuit’s argument, I think the Sixth Circuit properly recognized and addressed the relevant issues in its decision in Foreman v. TriHealth, Inc. decision:
But at the pleading stage, it is too early to make these judgment calls. ‘In the absence of further development of the facts, we have no basis for crediting one set of reasonable inferences over the other. Because either assessment is plausible, the Rules of Civil Procedure entitle [the three employees] to pursue [their imprudence] claim (at least with respect to this theory) to the next stage….’2
This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth ‘investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares’ because ‘the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….’ Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.3
One could argue that the Sixth Circuit’s Chief Judge Jeffery Sutton does not agree that ERISA’s disclosure requirements provide sufficient information to overcome the inherent informational advantage that plan sponsors enjoy in carrying the burden of proof on the issue of causation. Judge Sutton also suggests that too many cases are summarily dismissed prematurely based on this issue of causation, without necessarily all the relevant and legally required facts.
Plan sponsors often seek quick dismissals of ERISA cases, allegedly to avoid the high costs of discovery. However, as Judge Sutton suggested, there are various methods of allowing discovery while controlling costs. “Controlled” discovery, limited to documents and minutes from a plan’s investment meetings, would probably suffice, assuming such documents and minutes actually exist.
The Solicitor General of the United States addressed the burden of proof on causation issue back in 2018 in connection with the Brotherston v. Putnam Investments, LLC4 case. While the Solicitor General supported shifting the burden of proof to plan sponsors, he advised SCOTUS against taking the case since it was before the Court as an interlocutory appeal. The Court followed the Solicitor General’s advice.
This case needs to be heard and the issues involved resolved once and for all without letting another 6 years pass and more plan participants suffer needless financial losses.
Given the significance of this decision and the impact of the burden of proof re causation in ensuring that 0lan participants are being treated equitably and that ERISA remains meaningful, hopefully the plan participants will seek certiorari from SCOTUS, who would presumably hear the case given the divide between the courts and the importance of ERISA and plan participants.
Stay tuned!
Notes 1. Pizarro v. Home Depot, Case No. 22-13643 (11th Cir. 2024) decided 8/2/2024 2. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022). (TriHealth) 3. TriHealth, 453. 4. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018).
Testimony of James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA® re QDIAs and Annuities as QDIAs
In my practice, I often refer to as the “fiduciary responsibility trinity” (Trinity). The Trinity consists of the Tibble v. Edison International1 (Tibble I), Brotherston v. Putnam Investments, 2 (Brotherston), and Hughes/Northwestern3 decisions.
Tibble recognized the Restatement of Trusts (Restatement) as a legitimate resource in resolving fiduciary issues and ruled that a plan sponsor has an ongoing fiduciary duty to monitor plan investment options for prudence.
Brotherston ruled that comparable index funds can be used for benchmarking purposes, citing Section 100 b(1) of the Restatement.
Hughes/Northwestern ruled that a plan sponsor has a fiduciary duty to ensure that each investment option within a plan is prudent and to remove any that are not.
The question that I am constantly asked by plan sponsors and other investment fiduciaries, as well as attorneys, is “so how do I use all this to evaluate the fiduciary prudence of an investment option?” Since SCOTUS recognized the legitimacy of the common law of trusts in resolving fiduciary questions in its Tibble decision4, and since the Restatement of Trusts (Restatement) is essentially the codification of the common law of trust, I always suggest consulting the Restatement for guidance.
Three comments within Section 90 of the Restatement, commonly known as the “Prudent Investor Rule,” provide a simple blueprint for selecting prudent investment options for ERISA plans.
Comment b states that “cost-conscious management is fundamental to prudence in the investment function.”5
Comment f states that ”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.”6
Comment h(2) essentially says that actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent.7
Taken together, these three comments stress the importance of a properly conducted cost-benefit analysis in selecting prudent investment options. Cost-benefit analysis is routinely used in business to evaluate the viability of projects. Yet, the investment industry typically avoids a cost-benefit analysis, as it knows what the results would show. Academic studies have consistently concluded that actively managed funds are typically cost-inefficient, most even failing to cover their costs:
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
It should be noted that when the SEC announced Regulation Best Interest, Chairman Jay Clayton also stressed the importance of cost-efficiency relative to acting in the best interest of customers:
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.11
[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.12
In 2015, the DOL issued Interpretive Bulletin 15-01 (IB 15-01).13 IB 15-01 reinstated earlier language from Interpretative Bulletin 94-114, language that supports the previously mentioned Restatement comments and the potential importance of cost-benefit analysis in evaluating the fiduciary prudence of plan investments:
Consistent with fiduciaries’ obligations to choose economically superior investments….[Plan fiduciaries should consider factors that potentially influence risk and return. 15
[B]ecause every investment necessarily causes a plan to forgo other investment opportunities, an investment will not be prudent if it would provide a plan with a lower expected rate of return than available alternative investments with commensurable degrees of risk or is riskier that alternative available investments with commensurate rates of return.16
The Active Management Value Ratio As a fiduciary risk management consultant, I created a simple metric, the “Active Management Value Ratio,” (AMVR) that allows investors, investment fiduciaries, and attorneys to quickly perform cost-benefit analyses of actively managed investments. My favorite comment about the AMVR has been “it’s simply third grade math…but very persuasive third grade math.” The attached sample AMVR slide shows how easy the AMVR calculations are using “Humble Arithmetic” – subtraction and division. The actual AMVR formula is the actively managed fund’s incremental correlation-adjusted costs divided by the actively managed fund’s incremental risk-adjusted returns.
Interpreting the AMVR is equally easy, consisting of answering two questions:
Did the actively managed fund provide a positive incremental return?
If so, did the actively managed fund’s positive incremental return exceed the fund’s incremental costs?
If the answer to either question is “no,” then the actively managed fund is neither cost-efficient nor prudent under the Restatement’s guidelines.
The AMVR is based on the research findings and concepts of investment icons Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel:
The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.17– Dr. William F. Sharpe
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 the incremental fees for active management are really, really high – on average, over 100% of incremental returns.18– Charles D. Ellis
Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover. 19– Burton G. Malkiel
Selecting prudent investments is just that simple. Cost-benefit analysis is consistent with applicable legal standards. Using an objective analysis metric, can an investment be projected to provide a commensurate return to an investor for the additional costs and risks associated with the investment in question?
“Black Box” Target Date Funds and Qualified Designated Investment Alternatives (QDIAs) Studies have consistently suggested that the majority of the public is financially illiterate when it comes to personal finances and investing. Target Date Funds (TDFs) were designed to simplify the investment process for investors, including plan participants, by creating professionally designed asset allocation plans designed to prudently reduce investment risk as an investor got older, while still providing a prudent return in anticipation of retirement.
Nice in theory, but actual results are still questionable given the disparity in risk among TDFs once the TDF owner reaches their “target” retirement date. In many cases, the asset allocation errors have been attributed the use of “black box” portfolio optimizers/asset allocation computer applications, many of which utilize Markowitz’s “Mean Variance Optimization” (MVO) theory. The issues involved with the use of MVO by such “black box” computer applications are well-known and were summed up perfectly by Michaud:
Although Markowitz efficiency is a convenient and useful theoretical framework for defining portfolio optimality, in practice it is an error-prone procedure that often results in “error-maximized” and “investment irrelevant” portfolios.20
In practice, the most important limitations of MV optimization are instability and ambiguity. Small changes in input assumptions often imply large changes in the optimized portfolio….21
In other words, molehills of erroneous assumptions result in mountains of erroneous projections out. Plan participants deserve better and ERISA demands better.
Notes 1.Tibble v. Edison International, Inc., 135 S. Ct. 1823, 1828 (2015) (Tibble). 2. Brotherston v. Putnam Investments, 907 F.3d 17 (1st Cir. 2018). 3. Hughes v. Northwestern University, 595 U.S. ___ (2022). 4. Tibble 5. Restatement (Third) of Trusts, Section 90, cmt. b. American Law Institute, All rights reserved. 6. Restatement (Third) of Trusts, Section 90, cmt. f. American Law Institute, All rights reserved. 7. Restatement (Third) of Trusts, Section 90, cmt. h(2). American Law Institute, All rights reserved. 8. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010). 9. 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. 10. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016. 11. SEC Release 34-86031, “Regulation Best Interest: The Broker-Dealer Standard of Conduct (Reg BI), 279. 12. Reg BI, 279. 13. DOL Interpretative Bulletin 15-01, 29 CFR.2015-01. 14. DOL Interpretative Bulletin 94-01, 29 CFR.1994-015. 15. DOL Interpretative Bulletin 15-01, 29 CFR.2015-01. 16. DOL Interpretative Bulletin 15-01, 29 CFR.2015-01. 17. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm. 16. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c 17. Burton G. Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460. 18. Michaud at XIV 19. Michaud, 2.
“Don’t make the process harder than it is.” – Jack Welch, former GE CEO
When I meet with a prospective client, this is what I always tell them. Then I show them how their current plan is exposing them to unnecessary fiduciary liability exposure.
I continue to see posts and comments about how plan participants want annuities and guaranteed income products. When a plan member brings that issue up, my response is “who cares what plan participants want. You shouldn’t.” A plan sponsor’s fiduciary reality is defined by ERISA and the Restatement of Trusts, not by what plan participants allegedly want or what plan advisers and/or consultants may recommend. nor by the transitory and possibly uneducated wishes of plan participants.
Nowhere in ERISA does it mention any duty to provide investment alternatives that plan participants want. Annuity advocates respond with “that’s horrible” and make unfounded claims about moral and ethical duties to offer their imprudent investment products. Note, this is the same industry that deliberately mislead courts for years with claims that they had reports indicating that 95 percent of injured plaintiffs dissipated their injury awards within five years, also known as the annuity industry’s “squandering plaintiff” ruse. All this was done to try to get courts to require that injured victims accept structured settlements involving annuities, even as the annuity industry was misrepresenting the actual value of such settlements.1
The goal of the annuity industry’s fraud was to convince courts to require that any monetary award given to an injured victim be in the form of a structured settlement involving an annuity. Fortunately, most courts saw through this ruse, especially when the annuity industry was unable to produce the alleged studies supporting their “squandering plaintiff” claims.2
My fear is that we are seeing a repeat performance of these misrepresentations with relation to the annuity industry’s push for inclusion of annuities and “guaranteed income” products in 401(k) and other ERISA pension plans. One of the services that I provide as part of my fiduciary risk management consultant practice is fiduciary oversight services. Whenever income annuities are involved, I prepare a breakeven analysis like I did during my days as a plaintiff’s personal injury attorney facing the defense’s “squandering plaintiff” argument.
Shown below is a breakeven analysis based on a 65 year-old male purchasing an income annuity. A proper annuity breakeven analysis should factor in both present value, to account for the time value of money, and mortality risk, to factor in the odds that the annuity annuity may not survive long enough to recover the principal originally paid to purchase the annuity. My experience has been that most investors agree with Mark Twain’s famous quote – “I am more concerned with the return OF my money than I am the return ON my money.
As the analysis below shows, even if the 65 year-old purchaser in this example beat the odds and lived to be 100, the owner still would not break even. If mortality risk is factored in, the annuity owner would fall woefully short of breaking even, over $30,000 short!
Fortunately, the reports are that most plan sponsors are not falling for the annuity industry’s annuity and “guaranteed income” marketing push. I am always reminded of what the late Peter Katt, a fee-only insurance adviser, used to say about evaluating insurance products – “At what cost?” For additional information about the inherent fiduciary liability issues with annuities and “guaranteed income” products, read my recent post.
Cost-Benefit Analysis Cost-benefit analysis is commonly used in the business world to assess the viability of a project. Despite the simplicity of cost-benefit analysis, far too many investment fiduciaries, including plan sponsors, do not employ the strategy, especially given the consistent finding of studies finding that the overwhelming majority of actively managed mutual funds are cost-inefficient, with many not even able to cover their costs2
99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.3
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.4
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.5
Do costs exceed benefits? How much simpler could fiduciary prudence be for investment fiduciaries. Since studies show that humans are visually oriented, I created a visual metric, the Active Management Value Ratio (AMVR). I teach my clients, as well as investment fiduciaries, attorneys, and investors, how to use the AMVR to quickly calculate the cost-efficiency and fiducairy prudence of an actively managed mutual fund relative to a comparable index fund. The AMVR is based on the research of investment icons, including Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel.
The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.6
So, the incremental fees for an actively managed mutual fund realtive 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 the incremental fees for active management are really, really high – on average, over 100% of incremental returns.7
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.8
There are actually two forms of the AMVR, one that uses just a fund’s nominal, or publicly reported performance data, and a second version, which incorporates Miller’s Active Expense Ratio, which allows an attorney or investment fiduciary to detect both a fiduciary breach and the projected resulting monetary damages, using Miller’s Active Expense Ratio. Miller explained the importance of the AER 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 indexs.9
The two-column version is based on the funds’ nominal performance data. In this example, a plan sponsor can easily see that the actively managed fund is cost-inefficient, thus imprudent relative to the comparable index fund, since the active fund provides no benefit for the additional/incremental costs. Since studies have shown that most actively managed funds are cost-inefficient relative to comparable index funds, the two-column AMVR is a quick way to evaluate actively managed funds with minimal data requirements.
When questions of potential legal liability are involved, the three-column AMVR is the preferred option since it allows a fiduciary to determine both potential liability exposure and the projected cost of damages from such breach of fiduciary dutiesby incorporating Miller’s AER. In this example, treating the underperformance of the actively managed fund as an opportunity cost, the projected cost would be 4.83 per share (1.95 + 2.88).
Based on the research of both the GAO and the DOL, showing that each additional one percent of costs/fees reduces an investor’s return by approximately 17 percent over 20 year period, the investor would suffer a projected loss of 82 percent of their end-return from the cost-inefficient actively managed fund.10
Fortunately, the AMVR provides a quick and easy way for a plan sponsor to proactively detect such potential fiduciary breaches using “humble arithmetic,” and to protect their plan participants by ensuring that the investment options offered within the plan are cost-efficient, thus prudent. Fiduciary risk management literally can, and should be that simple.
Going Foward While there are some other proprietary techniques and strategies that we use to reduce potential fiduciary liability exposure, the strategies discussed here are key parts in our process simplification model which we refer to as our KISS model – Keep It Simple and Smart!
Smart people do not assume unnecessary risk. Going back to the issue of annuities within plans, plan participants desiring annuities or “guaranteed income” products still have the opportunity to purchase those products outside of the plan, allowing the plan sponsor to avoid any liability issues.
Fiduciary liability is all about employing prudent processes in managing ERISA plans. So don’t make the fiduciary process harder than it is.
That said, we always suggest to our clients to insist that their plan adviser provide then with written AMVR analyses on funds and breakeven analyses on annuities using the exact methods shown here. It will make a plan sponsor’s life easier and, if an adviser refuses (and most do), this will let a plan sponsor know to keep looking for a better adviser candidate.
Notes 1. Jeremy Babener, “Justifying the Structured Settlement Tax Subsidy: The Use of Lump Sum Settlement Monies,” NYU Journal of Law & Business (Fall 2009), 36 (Babener); Laura Koenig, “Lies, Damned Lies, and Statistics: Structured Settlements, Factoring, and the Federal Government,” Indiana Law Journal, Vol. 82, Issue 3, Article 6, available at https:www.repository.law.indiana.edu/ilj/vol82/iss3/ 6. (Koenig). 2. Babener, Koenig. 3. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010). 4. 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. 5. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016. 6. William F. Sharpe, “The Arithmetic of Active Investing,” available online t https://web.stanford.edu/~wfsharpe/art/active/active.htm. 7. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c 8. Burton G. Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460. 9. 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. 10. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study).
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.
James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®
A [fiduciary] is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is the standard of behavior….1
Consistent with fiduciaries’ obligations to choose economically superior investments,.. [P]lan fiduciaries should consider factors that potentially influence risk and return.2
Fiduciary law is a combination of three types of law–trust, agency and equity. The basic concept of fiduciary law is fundamental fairness.
SCOTUS has consistently recognized the fiduciary principles set out in the Restatement (Third) of Trusts (Restatement) as guidelines for fiduciary responsibility, especially for plan sponsors.
ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.2
Under the Restatement, loyalty and prudence are two of the primary duties of a fiduciary. A fiduciary’s duty of loyalty requires that a plan sponsor act solely in the best interests of the plan participants and their beneficiaries. A fiduciary’s duty of prudence requires that a plan sponsor exercise reasonable care, skill, and caution in managing a plan, specifically with regard to controlling unnecessary costs and risks.
The key question in evaluating annuities, or any other investment, should always be “at what cost?” With annuities, you generally have annual costs as well as additional optional costs for various “bells and whistles.” While costs vary, a basic average annual cost for immediate annuities seems to be 0.7 percent. The average costs for various additional options with all annuities seems to be an additional 1.0 percent. However, it is a plan sponsor’s duty to always ascertain the exact costs.
Plan sponsors need to always remember this mantra – “Costs matter.” Costs do matter, a lot. The General Accounting Office has stated that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a twenty year period. 3
Against that backdrop, plan sponsors are now confronted with the potential issues of including annuities and within a 401(k) plan, even thought these is no legal, moral, or other type of requirement to do so. I believe that annuities are inappropriate for 401(k) and 403(b) plan sponsors, as well as other investment fiduciaries such as registered investment advisers and trustees and are potential fiduciary liability traps, as they are structured to best serve the annuity issuer’s “best interests,” not those of an annuity owner. The following example of a typical income annuity shows a breakeven analysis for a 65-year old purchasing a garden-variety income annuity
Annuities An exhaustive analysis of annuities is beyond the scope of this post. I simply want to address three of the most common types of annuities and some of the fiduciary issues associated with each. One of the fiduciary issues involved with annuities is their complexity. The analyses herein will be based on the simple, garden variety of each of the three annuities.
1. Immediate Annuities (aka Income Annuities} These annuities are often recommended to provide supplemental income in retirement. In most cases, immediate annuities can be used to provide income for life or for a certain period of time, e.g., 5, 10, 15 or 20 years.
Peter Katt was an honest and objective insurance adviser. During my compliance career, he was my trusted go-to resource. While he passed away in 2015, the lessons I learned from him will always be invaluable. I strongly recommend to investors and investment fiduciaries that they Google his name and read his articles, especially those he wrote for the AAII Journal.
Katt’s thought on immediate annuities include:
The immediate annuity is for people who want the absolute security that they can’t outlive their nest egg. The problem is that there is nothing left over for your heirs.4
While annuities often offer options to address this issue, such options often result in reduced monthly payments and/or additional costs.
Katt always said to get the annuity salesmen to provide a written analysis providing the breakeven analysis for an annuity, the estimated time that would be required for an annuity owner to recover their original investment in the annuity. He told me that breakeven periods of twenty years or more are common, making it unlikely that the annuity owner will ever recover their original investment. And remember, with a life-only immediate annuity, once the annuity owner dies, the balance in the annuity goes to the annuity issuer, not the annuity owner’s heirs.
The sample breakeven analysis shown below shows the odds a 65 year old purchasing a simple income annuity paying 5 percent annually would face of not even breaking even, even if they lived to be 100. The example shows why it is importance to factor in both present value and mortality risk in evaluating the prudence of a garden-variety annuity.
If at some point, the annuity owner realizes that they made a mistake and wants to get out of the annuity by selling it, the purchaser, at best, is going to base the offering price on the annuity’s present value, not the original face value. In some cases, the purchaser will discount the offering price even further, using the mortality risk-based value.
This is why I often refer to the annuity industry’s attempt to make courts order that cases involving significant amounts of money include “structured settlements” that include annuities, what I refer to as “victimizing the victim.” For years, the annuity industry mislead the courts in an effort to persuade courts to require settlements to include annuities by claiming to have research showing that over 90 percent of plaintiffs receiving large sums outright squandered the money within 5 years. When finally pressed to produce such research, the annuity industry admitted that there was no such research.5
Katt also said to always ask the annuity salesman for the APR that was used in calculating the breakeven point. The APR is the interest rate that annuity issuers typically use in determining an annuity’s payments. In the example above, the applicable APR is 5 percent.
One of the drawbacks with immediate annuities is that once an interest rate is set, that will be the applicable interest rate for the period of the annuity. Again, some annuities may offer options to avoid this inflexibility…at an additional cost.
The inflexibility of an annuity’s interest rate results in purchasing power risk for an annuity owner. This risk increases as the period of the annuity increases. Purchasing power risk refers to the risk that the annuity’s payments will lose their buying power over the years due to inflation. Some annuities provide for “step-ups” in rates…at an additional cost.
Katt’s advice-anyone considering an immediate annuity should first build a balanced portfolio consisting of stocks and bonds to ensure flexibility, and then invest augment that portfolio with a reasonable am0unt in the immediate annuity. While some annuity salesmen will argue for an “all or nothing” approach in order to maximize their commission. Prudent investors will follow Katt’s advice.
Perhaps the strongest argument against including immediate annuities in 401(k) and other pension plans comes from a study by three well-respected experts on the subject. In analyzing when a Single Premium Immediate Annuity (SPIA), probably the most popular type of immediate annuity, would make sense, the three experts stated that
Results suggest that only when the possibility of outliving 70 percent or more of a cohort exists, and then only at elderly ages. For ages younger than 80, assets are best kept within the family, because both inflation and possible future market returns have time to do better than SPIA lifetime sums.6
Based upon my experience, very few 401(k) plans have plan participants aged 80 or older. I predict that plan sponsors who decide to offer immediate annuities, in any form, in their plans can expect to see that quote again, especially cases involving litigation.
2. Fixed Indexed Annuities (aka Equity Indexed Annuities) Target date funds (TDFs) are controversial investments that attempt to create investment portfolios that are appropriate based on the investor’s estimated retirement, or target, date. Target date funds have typically designed portfolios consisting of equity and fixed income investments.
There have been reports suggesting that the annuity industry may be trying to include some form of equity indexed annuities (EIAs) as an element in TDFs in 401(k) and 403(b) plans. So, what would be wrong with that? Dr. William Reichenstein, finance professor emeritus at Baylor University sums up the primary issue perfectly.
The designs of equity index annuities (EIAs) and bond indexed annuities ensure that they must offer below-market risk-adjusted returns compared with those available on portfolios of Treasurys and index funds. Therefore, this research implies that indexed annuity salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.6
While EIAs/FIAs are technically insurance products, not securities, Dr. Reichenstein’s analysis is still applicable with regard to a fiduciary’s duties of loyalty and prudence. If the design of these products ensures that they cannot offer competitive returns to those of alternative investments, then how does a plan sponsor, or any fiduciary for that matter, plan to meet their fiduciary duty of loyalty and prudence? Would the inclusion of EIAs in either TDFs, or in 401(k) plans in general. potentially create unnecessary fiduciary liability exposure for plan sponsors or other investment fiduciaries,
As regulators emphasize, before an insurance agent can sell an annuity, he or she must perform due diligence to ensure that the investment offered ex ante competitive returns. Therefore, it is appropriate to compare the net returns available in an equity-indexed annuity to those available on similar-risk investments held outside an annuity.7
[By] design, [equity]indexed annuities cannot add value through security selection ….[T]he hedging strategies [used by equity-indexed annuities] ensure that the individuals buying equity-indexed annuities will bear essentially all the risks. Consequently, all indexed annuities must (ital) produce risk-adjusted returns that trail those offered by readily available marketable securities by their spread, that is, by their expenses including transaction costs.8
Furthermore, by design, indexed annuities typically impose restrictions on the amount of return that an investor can actually receive. Therefore, the combination of the design of these products and the restrictions on returns typically imposed by EIAs/FIAs ensure a fiduciary breach.
So, even though the annuity industry markets these equity indexed annuities by emphasizing stock market returns, the majority of fixed indexed annuity owners are guaranteed to never receive the actual returns of the stock market. While some annuity firms are marketing so-called “uncapped” equity indexed annuities, they may still impose restrictions, and such “uncapped” returns…come with additional costs.
The restrictions and conditions that equity indexed annuities naturally vary. For example, during my time as a compliance director, the equity indexed annuities I saw typically imposed a 8-10 percent cap and a participation rate of 80 percent. What that meant was that regardless of the returns of the applicable market index, with a cap of 10 percent, the most the annuity owner could receive was 10 percent of the index’s return.
As if that was not unfair enough, that 10 percent return was then further reduced by the annuity’s participation rate. So, with a participation rate of 80 percent, the maximum return an investor could receive in our example was 8 percent.
More recently, the point has been made that while a fixed indexed annuity may claim to only impose a certain amount of spread, for instance a 2 percent “spread” that would only reduce the annuity owner’s realized return by 2 percent on a capped return of 10 percent, “humble arithmetic” indicates that the impact of the 2 percent “spread” a capped 10 percent return would be a 20 percent reduction in return (A basis point equals 1/100th of 1 percent, so 100 basis points equals 1 percent. 200 basis points divided by 1000 basis points equals 20 percent).
Reichenstein points out even more inequities, noting that
Because interest rates and options’ implied volatilities change, the insurance firm almost always retains the right to set at its discretion at least one of the following: participation rate, spread, and cap rate.9
And finally, a simple explanation of how equity indexed annuity companies aka indexed fixed annuities further manipulate returns to ensure that they protect their interests first.
From AmerUS Group financial statements, ‘Product spread is a key driver of our business as it measures the difference between the income earned on our invested assets and the rate which we credit to policy owners, with the difference reflected as segment operating income. We actively manage product spreads in response to changes in our investment portfolio yields by adjusting liability crediting rates while considering our competitive strategies….’ This spread ensures that the annuity will offers noncompetitive risk-adjusted returns.10
I could go on to discuss additional issues such as single entity credit risk and illiquidity risk, but I think investment fiduciaries get the picture. The evidence against equity index annuities establishes that they are a fiduciary breach simply waiting to happen. I strongly recommend that plan sponsors and other investment fiduciaries read Reichenstein’s analysis before deciding to offer fixed indexed annuities, in any shape or form, in their plans or to clients. With no legal obligation to offer annuities of any type, the obvious risk management question is – “why go there?”
3. Variable Annuities Any fiduciary that sells, uses, or recommends a variable annuity (VA) has probably breached their fiduciary duty…period. Annuity expert Moshe Milevsky summed it up perfectly with the following observations and opinions in his classic article, :The Titanic Option”:
Exhibit A Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.
[T]he fee [for the death benefit] is included in the so-called Mortality and Expense (M&E) risk charge. The M&E risk charge is a perpetual fee that is deducted from the underlying assets in the VA, above and beyond any fund expenses that would normally be paid for the services of managed money.11
[T]he authors conclude that a simple return of premium death benefit is worth between one to ten basis points, depending on purchase age. In contrast to this number, the insurance industry is charging a median Mortality and Expense risk charge of 115 basis points, although the numbers do vary widely for different companies and policies.12
The authors conclude that a typical 50-year-old male (female) who purchases a variable annuity—with a simple return of premium guaranty—should be charged no more than 3.5 (2.0) basis points per year in exchange for this stochastic-maturity put option. In the event of a 5 percent rising-floor guaranty, the fair premium rises to 20 (11) basis points. However, Morningstar indicates that the insurance industry is charging a median M&E risk fee of 115 basis points per year, which is approximately five to ten times the most optimistic estimate of the economic value of the guaranty.13 (emphasis added)
Excessive and unnecessary costs violate the fiduciary duty of prudence, especially when they produce a windfall for an annuity issuer at the expense of the annuity owner. The value of a VA’s death benefit is even more questionable given the historic performance of the stock market. As a result, it is unlikely that a VA owner would ever need the death benefit. These two points have resulted in some critics of VAs to claim that a “VA owner needs the death benefit like a duck needs a paddle.”
Exhibit B Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.
At what cost? VAs often calculate a VAs annual M&E charge/death benefit based on the accumulated value within the VA, even though contractually most VAs limit their legal liability under the death benefit to the VA owner’s actual investment in the VA.
This method of calculating the annual M&E, known as inverse pricing, results in a VA issuer receiving a windfall equal to the difference in the fee collected and the VA issuer’s actual costs of covering their legal liability under the death benefit guarantee.
As mentioned earlier, fiduciary law is a combination of trust, agency and equity law. A basic principle of fiduciary law is that “equity abhors a windfall.” The fact that VA issuers knowingly use the inequitable inverse pricing method to benefit themselves at the VA owner’s expense would presumably result in a fiduciary breach for fiduciaries who recommend, sell or use VAs in their practices or in their pension plans.
The industry is well aware of this inequitable situation. John D. Johns, a CEO of an insurance company, addressed these issues in an article entitled “The Case for Change.”
Another issue is that the cost of these protection features is generally not based on the protection provided by the feature at any given time, but rather linked to the VA’s account value. This means the cost of the feature will increase along with the account value. So over time, as equities appreciate, these asset-based benefit charges may offer declining protection at an increasing cost. This inverse pricing phenomenon seems illogical, and arguably, benefit features structured in this fashion aren’t the most efficient way to provide desired protection to long-term VA holders. When measured in basis points, such fees may not seem to matter much. But over the long term, these charges may have a meaningful impact on an annuity’s performance.14
In other words, inverse pricing is always a breach of a fiduciary’s duties of both loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without any commensurate return, which would presumably violate Section 205 of the Restatement of Contracts.
Exhibit C Benefit – VAs allow their owners the opportunity to invest in the stock market and increase their returns.
VAs offer their owners an opportunity to invest in equity-based subaccounts. Subaccounts are essentially mutual funds, usually similar to the same mutual funds that investors can purchase from mutual fund companies in the retail market.
While there has been a trend for VAs to offer cost-efficient index funds as investment options, many VA subaccounts are essentially same overpriced, consistently underperforming, i.e., cost-inefficient, actively managed mutual funds offered in the retail market. As a result, VA owners’ investment returns are typically significantly lower than they would have been when compared to returns of comparable index funds.
Exhibit D Benefit – VAs provide tax-deferral for owners.
So do IRAs. So do any brokerage account as long as the account is not actively traded. However, dividends and/or capital gain distributions are taxed when they occur.
The key point here is that IRAs and brokerage accounts usually do not impose the high costs and fees associated with annuities. This is especially true of VAs, where annual fees of 3 percent or more are common, even higher when riders and/or other options are added.
Remember the earlier 1/17 note? Multiply 3 by 17 to see the obvious fiduciary issues regarding the fiduciary duties of loyalty and prudence.
Although not an issue for plan sponsors, another “at what cost” fiduciary issue for other investment fiduciaries has to do with the adverse tax implications of investing in non-qualified variable annuities (NQVA). Non-qualified variable annuities are essentially those that are not purchased within a tax-deferred account, e.g., a 401(k)/403(b) account, an IRA account.
When investors invest in equity investments, they typically are not taxed on the capital appreciation until such gains are actually realized, such as when they sell the investment or, in the case of mutual funds, when the fund makes a capital gains distribution.
In many cases, investors can reduce any tax liability by taking advantage of the special reduced tax rate for capital gains. However, withdrawals from a NQVA do not qualify for the lower capital gains tax. All withdrawals from a NQVA are considered ordinary income, and thus taxed at a higher rate than capital gains. An investment that increases its owner’s tax liability by converting capital gains into ordinary income is hardly prudent or in an investor’s “best interest.”
Bottom line – there are other less costly investment alternatives available that provide the benefit of tax deferral. While they may not offer the same guaranteed income, they provide other significant benefits, while avoiding some of the fiduciary liability risks associated with VAs, e.g., reduced flexibility, purchasing power risk, higher taxes.
Exhibit E Benefit: Annuity owners do not pay a sales charge, so more of their money goes to work for them.
The statement that variable annuity owners pay no sales charges, while technically correct, is misleading. Variable annuity salesmen do receive a commission for each variable annuity they sell. Commissions paid on VA sales are typically among the highest paid in the financial services industry.
While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through a variable annuity’s various fees and charges.
To ensure that the cost of commissions paid is recovered, the annuity issuer typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for a specific initial surrender charge during the first year, then decreasing 1 percent each year thereafter until the eighth year, when the surrender charges would end. There are some surrender charge schedules that charge a flat rate over the entire surrender charge period.
Going Forward I have been asked by clients and the media for my opinion on what I see for fiduciary law and 401(k) litigation going forward. My answer-a significant increase in litigation.
What too many plan sponsors fail to recognize and appreciate is the fact that those recommending the inclusion of annuities in plans generally are not doing so in a fiduciary capacity and therefore arguably have no potential fiduciary liability. Plan sponsors, trustees and other investment fiduciaries that follow such advice will typically have unlimited personal liability exposure based on the issues discussed herein.
Plan sponsors and other investment fiduciaries have a duty to independently investigate, evaluate, select and monitor the investment options they select or recommend.
Over and above its duty to make prudent investments, the fiduciary has a duty to conduct an independent investigation of the merits of a particular investment….A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.15
The failure to make any independent investigation and evaluation of a potential plan investment” has repeatedly been held to constitute a breach of fiduciary obligations.16
A determination whether a fiduciary’s reliance on an expert advisor is justified is informed by many factors, including the expert’s reputation and experience, the extensiveness and thoroughness of the expert’s investigation, whether the expert’s opinion is supported by relevant material, and whether the expert’s methods and assumptions are appropriate to the decision at hand. One extremely important factor is whether the expert advisor truly offers independent and impartial advice.17
Defendants relied on FPA, however, and FPA served as a broker, not an impartial analyst. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best. A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative. FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of “can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce.18
These fiduciaries duties are inviolate. There are no “mulligans” or “do overs” in fiduciary law. As the courts have repeatedly pointed out, “A pure heart and an empty head’ are no defense to allegations of the breach of one’s fiduciary duties.19
If anything positive comes out of the current debate over the inclusion of annuities in 401(k) plans, hopefully it will be a greater recognition and appreciation of the importance of one’s fiduciary duties by plan sponsors and other investment fiduciaries.
Plan sponsors and other investment fiduciaries considering offering/recommending annuities, in any form, need to always remember some basic rules of fiduciary law:
1. There are no “mulligans” or “do-overs” in fiduciary law. 2. There is no balancing of good versus bad features/acts in fiduciary accounts. Fiduciary errors are strictly “one and done.” 3. Courts in fiduciary cases often admonish defendant fiduciaries that “a pure heart and an empty head” are no defense to claims of a fiduciary breach. Smart fiduciaries do not voluntarily assume unnecessary fiduciary liability exposure.
In my practice as a fiduciary risk management consultant, I focus on two basic principles emphasized in Section 90 of the Restatement: cost-consciousness/cost-efficiency and commensurate return. Three comments within Section 90 of the Restatement, commonly known as the “Prudent Investor Rule,” provide a simple blueprint for selecting prudent investment options for ERISA plans.
Comment b states that “cost-conscious management is fundamental to prudence in the investment function.”
Comment f states that ”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.”
Comment h(2) essentially says that actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent.
As the exhibits provided herein show, annuities typically fail on all three points due to excessive fees and failure to provide a commensurate return. Add in the fact that plan sponsors have no obligation, legal or otherwise, to provide annuities or any type of “guaranteed income” product. Common sense, as well as the lack of any legal requirement to offer such products, dictate that a prudent plan sponsor will avoid these products altogether given the inherent liability issues in such products. A prudent plan sponsor will allow a plan participant interested in such products to purchase them outside of the plan, thereby avoiding any potential liability exposure for the plan sponsor.
Resources The article by Frank, Mitchell, and Pfau provides detailed instructions on how to perform annuity breakeven analyses using Microsoft Excel.
Notes 1. Meinhard v. Salmon, 249 N.Y. 458, 464 (1928). 2. 29 CFR 2509.2015-01. 3. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”). http://www.DepartmentofLabor.gov/ebsa/pdf; “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 4. Peter C. Katt, “The Good, Bad, and Ugly of Annuities,” AAII Journal, November 2006, 34-39 5. Jeremy Babener, “Justifying the Structured Settlement Tax Subsidy: The Use of Lump Sum Settlement Monies,” NYU Journal of Law & Business (Fall 2009), 36. 6. Larry R. Frank, Sr., John B. Mitchell, and Wade Pfau, “Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios,” Journal of Financial Planning, April 2014, 38-7. 7. Reichenstein, 302. 8. Reichenstein, 303. 9. Reichenstein, 309. 10. Reichenstein, 309.. 11. Moshe Miklevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126, 92. (Milevsky and Posner) 12. Milevsky and Posner, 94. 13. Milevsky and Posner, 122. 14. John D. Johns, “The Case for Change,” Financial Planning, September 2004, 158-168. 15. Fink v. National Saving & Loan, 772 F.2d 951 (D.C. Cir. 1985); Donovan v. Cunningham, 716 F.2d. 1455, 1467; Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981). 16. Liss v. Smith, 991F.Supp. 278 (S.D.N.Y. 1998). 17. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003). (Gregg) 18. Gregg, 842. 19. Cunningham, 1461.
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.
James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®
SCOTUS may soon have yet another ERISA-related case to review. AT&T Services, Inc. recently petitioned SCOTUS for a writ of certiorari to review the Ninth Circuit’s decision in Bugielski v. AT&T Services, Inc. (AT&T). AT&T presented the question for the Court as follows:
Whether a fiduciary to an employee benefit plan causes the plan to engage in a prohibited transaction under Section 406(a)(1)(C) of the Employee Retirement Security Act of 1974 by entering into a routine, arm’s-length agreement for plan services.
The Ninth Circuit had answered the question in the affirmative. I thought the Ninth Circuit’s decision was well-reasoned and technically correct.
People often ask me to explain the concept of “prohibited transactions” in the context of ERISA. I have entered the cite for the Ninth Circuit’s decision into my phone so that I can now answer said question by simply providing with the cite for the Ninth Circuit’s decision. In my opinion,the strength of the Ninth Circuit’s decision was the fact that the court relied heavily on DOL and EBSA documents and opinions, as well as ERISA itself.
Whether SCOTUS grants cert remains to be seen. However, given my experience that few plan sponsors and other plan fiduciaries have a true understanding of (1) what ERISA requires them to do and not to do, and (2) the rules regarding prohibited transactions, I thought a review of the Ninth Circuit’s decision might be helpful
The Ninth Circuit’s opinion is nineteen pages long. So, my guess is that very few plan sponsors are going to take the time to read and/or do whatever is necessary to understand the Ninth Circuit’s decision or the general rules applicable to prohibited transactions. That is a shame, as it means they probably are in violation of such rules and simply do not realize their potential liability exposure.
In this post, I want to discuss some of the key fundamental points that the Ninth Circuit discussed in hopes of raising the consciousness of plan sponsors and other plan fiduciaries to the point that they realize a need to seek out experienced and knowledgeable ERISA counsel to address any concerns.
Normally, I omit internal cites in quotes in my posts. Several colleagues suggested that I leave them in to help readers who may want research the issues addressed without having to go back and forth to the “Notes” section.
The Employee Retirement Income Security Act of 1974 (“ERISA”) establishes standards for employee benefit plans to protect the interests of plan participants. See 29 U.S.C. § 1001. To that end, ERISA imposes a duty of prudence upon those who manage employee retirement plans, prohibits plans from engaging in transactions that could harm participants’ interests, and mandates disclosures to the United States Department of Labor.1
Specifically, Plaintiffs argue that this transaction was not exempt under §408(b)(2), which exempts from § 406’s bar service contracts or arrangements between a plan and a “party in interest” if (1) the contract or arrangement is reasonable, (2) the services are necessary for the establishment or operation of the plan, and (3) no more than reasonable compensation is paid for the services. 29 U.S.C. § 1108(b)(2); 29 C.F.R. § 2550.408b-2(a). For the contract or arrangement to be “reasonable,” the party in interest must disclose to the plan’s fiduciary all compensation the party expects to receive “in connection with” the services provided pursuant to the contract or arrangement. 29 U.S.C. § 1108(b)(2)(B), 29 C.F.R. § 2550.408b-2(c)(1)(iv); see also Reasonable Contract or Arrangement Under Section 408(b)(2)—Fee Disclosure, 77 Fed. Reg. 5632-01 (Feb. 3, 2012).2
Under § 406(a)(1)(C), a fiduciary “shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect … furnishing of goods, services, or facilities between the plan and a party in interest.” 29 U.S.C. § 1106(a)(1)(C). A “party in interest” includes “a person providing services to such plan.” Id. § 1002(14)(B).3
The Ninth Circuit pointed out that since the prohibited transaction rule is a per se rule, whether or not the violation caused any harm is immaterial. As the court pointed out repeatedly throughout the decision, ERISA and the associated regulations provide exemptions to allow plans to enter into “’service transaction” that keep plans running smoothly,” e.g., bookkeeping and administrative services.
[W]e know that Congress recognized that § 406(a)(1)(C) would prohibit necessary services; that is why it created an exemption. See 29 U.S.C. § 1108(b)(2)(A) (exempting contracts for “services necessary for the establishment or operation of the plan”)….[I]t would be “nonsensical” to read § 406(a)(1) “to prohibit transactions for services that are essential for defined contribution plans, such as recordkeeping and administrative services.” Id. at 584-85.4
The Department of Labor’s Employee Benefits Security Administration’s (“EBSA”) explanation for amending the regulation implementing § 408(b)(2) confirms our reading of § 406. In pertinent part, that explanation provides:
The furnishing of goods, services, or facilities between a plan and a party in interest to the plan generally is prohibited under section 406(a)(1)(C) of ERISA. As a result, a service relationship between a plan and a service provider would constitute a prohibited transaction, because any person providing services to the plan is defined by ERISA to be a “party in interest” to the plan. However, section 408(b)(2) of ERISA exempts certain arrangements between plans and service providers that otherwise would be prohibited transactions under section 406 of ERISA.5
The agency noted that “[p]ayments from third parties and among service providers can create conflicts of interest between service providers and their clients.” Id. at 5650. 6
The court then addressed a common situation in plans where a company that provides recordkeeping and/or administrative service also offers investment and/or investment advice, including proprietary products:
Finally, we are persuaded by the Department of Labor’s advisory opinion that a company that “provide[d] recordkeeping and related administrative services to retirement plans” and made available to those plans “a variety of investment options, including its own insurance company separate accounts and affiliated and unaffiliated mutual funds,” would be “a party in interest with respect to the plan” because it was “a provider of services.”[3] U.S. Dep’t of Labor, Opinion No. 2013-03A. (emphasis added)7
The Ninth Circuit then addressed the potential impact of fees and the need for greater transparency between plans and a party in interest:
Expenses, such as management or administrative fees, can sometimes significantly reduce the value of an account in a defined-contribution plan.” Tibble v. Edison Int’l, 575 U.S. 523, 526, 135 S.Ct. 1823, 191 L.Ed.2d 795 (2015). Therefore, if AT&T entered into bad deals—as Plaintiffs hypothesize—those fees could “significantly reduce” participants’ assets.8
The Court pointed out that ERISA does not necessarily prohibit such situations, but simply requires that greater disclosure and transparency is required in order to fulfill ERISA’s mission of protecting plan participants.
Instead, it simply ensures that, when transacting with a party in interest, a fiduciary understands the compensation the party in interest will receive from the transaction and determines that compensation is reasonable. See 29 C.F.R. § 2550.408b-2(a), (c), (d). This reading is consistent with ERISA’s broader aim to protect plan participants, as well as §§ 406 and 408’s aim to increase transparency around service providers’ compensation and potential conflicts of interest. See 29 U.S.C. § 1001; Reasonable Contract or Arrangement Under Section 408(b)(2)—Fee Disclosure, 77 Fed. Reg. at 5632. 9
Section 406(a)(1)(C) is not a complete ban; instead, it requires fiduciaries, before entering into an agreement with a party in interest, to understand the compensation the party in interest will receive, evaluate whether the arrangement could give rise to any conflicts of interest, and determine whether the compensation is reasonable. 29 C.F.R. § 2550.408b-2; see generally Reasonable Contract or Arrangement Under Section 408(b)(2)—Fee Disclosure, 77 Fed. Reg. 5632-01. Rather than frustrating “ERISA’s statutory purpose,” Oshkosh, 47 F.4th at 585, this scheme furthers it by ensuring fiduciaries understand the impact the transaction will have on participants’ interests. See 29 U.S.C. § 1001. 10
EBSA stated explicitly that the information the party in interest must disclose to the fiduciary about the compensation it expects to receive “in connection with” the services provided “will assist plan fiduciaries in understanding the services and in assessing the reasonableness of the compensation, direct and indirect, that the [party in interest] will receive.” Reasonable Contract or Arrangement Under Section 408(b)(2)—Fee Disclosure, 77 Fed. Reg. at 5635-36 (emphasis added). Put differently, the regulation contemplates that the fiduciary will assess the reasonableness of the compensation that the party receives “directly from the covered plan,” 29 C.F.R. § 2550.408b-2(c)(1)(viii)(B)(1) (defining “direct compensation”), and “from any source other than the covered plan,” id. § 2550.408b-2(c)(1)(viii)(B)(2) (defining “indirect compensation”). Reasonable Contract or Arrangement Under Section 408(b)(2)—Fee Disclosure, 77 Fed. Reg. at 5650. 11
This conclusion—that the fiduciary must consider all compensation the party in interest receives in connection with the services it provides the plan—is required by the text of the regulation, conforms to the structure and purpose of § 408(b)(2)’s requirements, and is reinforced by EBSA’s explanation for revising § 2550.408b-2. The first exemption requirement—that the contract or arrangement be “reasonable”—calls for the party in interest to disclose information to the fiduciary about the compensation the party in interest expects to receive in connection with the services provided under the contract with the plan. 29 C.F.R. § 2550.408b-2(c)(1)(iv). 12
The third requirement—that “no more than reasonable compensation is paid”—expects a fiduciary to consider this information….As EBSA explained, the point of disclosure is to provide information from which the fiduciary can make responsible decisions for the plan….the disclosed information “will assist plan fiduciaries in understanding the services and in assessing the reasonableness of the compensation” the party will receive). 13
EBSA was particularly concerned with the special risks presented by these fees. It recognized that “[p]ayments from third parties and among service providers can create conflicts of interest between service providers and their clients,” and these payments have “been largely hidden from view,” thereby preventing fiduciaries “from assessing the reasonableness of the costs for plan services.” Reasonable Contract or Arrangement Under Section 408(b)(2)—Fee Disclosure, 77 Fed. Reg. at 5650. (emphasis added)14
EBSA therefore implemented the regulation to “improve … transparency” and make it easier for fiduciaries to satisfy their “duty to consider compensation that will be received by a [party in interest] from all sources in connection with the services it provides to a covered plan” under the contract. (emphasis added)15
§ 408(b)(2) requires service providers to disclose all compensation they receive in connection with a plan because “plan fiduciaries need this information, when selecting and monitoring service providers,” to be able to “assess[] the reasonableness of the compensation paid for services and the conflicts of interest that may affect a service provider’s performance of services” and satisfy their duty of prudence).See Reasonable Contract or Arrangement Under Section 408(b)(2)—Fee Disclosure, 77 Fed. Reg. at 5632. 16
Going Forward In my opinion, AT&T’s reaction to the Ninth Circuit’s decision and the resulting decision to seek cert can be summed up in one word – transparency. Transparency is the financial service industry’s kryptonite. Transparency may well result in greater liability for plan advisers/plan providers or, at a minimum, allow for a more meaningful comparison of available investment alternatives for plans, furthering ERISA’s goals of protecting plan participants and providing meaningful investment options within pension plans.
If I were SCOTUS, I would deny AT&T’s petition for cert, as the Ninth Circuit already addressed and properly dismissed AT&T’s arms-length argument by recognizing that under ERISA, a prohibited transaction, as defined under ERISA, is a per se violation…period.
Moreover, § 406(a)(1)(C) contains no language limiting its application to non-arm’s-length transactions, and accepting AT&T’s “statutory intent” argument would undermine the scheme Congress enacted. Specifically, § 408(b)(2) broadly exempts from § 406’s bar transactions for “services necessary for the establishment or operation of the plan.” 29 U.S.C. § 1108(b)(2)(A). And the definition of “necessary” is similarly broad: a service is necessary if it “is appropriate and helpful to the plan obtaining the service in carrying out the purposes for which the plan is established or maintained.” 29 C.F.R. § 2550.408b-2(b). In other words, ERISA already contains an exemption for those “service transactions” that keep plans running smoothly, which are the very transactions AT&T argues should be exempt. We see no reason to fashion a judge-made exemption when Congress has already provided a statutory exemption. 17
As I suggested in an earlier post, perhaps SCOTUS should consider having an ERISA week during its next term given the ERISA cases currently pending before the Court and the AT&T case, with the Home Depot case potentially heading toward SCOTUS once the Eleventh Circuit hands down its decision.
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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.
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