A Curious Paradox: “Meaningful Benchmarks,” Fiduciary Prudence, and the Active Management Value Ratio

Posted on December 31, 2023 by jwatkins

James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®

Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing has happened.
Winston Churchill

Some courts continue to attempt to justify premature dismissals of 401(k) and 403(b) actions (collectively, “401(k) cases”) based on a court’s refusal to recognize index funds as “meaningful benchmarks” in determining whether a plan sponsor breached their fiduciary duties.1 Other courts have readily recognized comparable index funds as acceptable benchmarks in 401(k) cases, in most cases citing SCOTUS’ recognition of the Restatement of Trusts (Restatement) as a legitimate authority in resolving fiduciary issues.2

In the Tibble decision3, SCOTUS recognized the value of the Restatement in resolving fiduciary questions. SCOTUS noted that the Restatement essentially restates the common law of trusts, a standard often used by the courts. The two dominant themes running throughout the Restatement are the dual fiduciary duties of cost-consciousness and diversification within investment portfolios, the latter to reduce investment risk.

In my fiduciary risk management consulting practice, I rely heavily on five core principles from Section 90 of the Restatement to reduce fiduciary risk. Three of the five principles are cost-consciousness/cost-efficiency principles:

Comment h(2)’s commensurate return standard is a standard that I feel very few fiduciaries do, or can, meet if they include actively managed mutual funds in their plan. Actively managed funds start from behind in comparison to comparable passive/index funds due to the extra and higher expenses they incur from management fees and trading fees.

Advocates of active management often claim that active management provides an opportunity to overcome such cost issues. However, the evidence overwhelmingly indicates that very few do so, with most actively managed funds being unable to even cover their extra costs.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.4 

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

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.6

The First Circuit Court of Appeals has even suggested that plan sponsors wishing to avoid potential fiduciary liability for their selection of a plan’s investment options should consider comparable index funds as plan investment options.7

So, why are some courts continuing to ignore SCOTUS, the Restatement, and other federal circuit courts by refusing to accept comparable index funds as “meaningful benchmarks.” Why are some courts refusing to analyze 401(k) cases in terms of a more meaningful cost-efficiency approach instead of meritless arguments such as differing “strategies and goals” and/or the outdated active/passive debate, complete with the “apples-to-apples” argument?

Adopting a cost-efficiency approach, using a simple cost-benefit equation, will quickly and clearly indicate which available investment options are truly prudent, i.e., in the plan participants best interest. In adopting Reg BI, the SEC emphasized the inportance of recommending cost-efficient investment products and stratgies.8 Could it be that some courts, as well as the financial services industry, realize that the industries’ investment products are cost-inefficient and, in their present form, could never pass scrutiny under a cost-benefit analysis, much less a true fiduciary prudence standard?

How a legal action is framed is often a significant factor in the eventual outcome of the litigation. My argument in these cases has been that the primary focus in any ERISA action should always be consistency with the stated purposes of ERISA, namely protecting the rights guaranteed to employees under ERISA.

As mentioned earlier, the two dominant themes that run throughout ERISA are cost-consciousness/cost-efficiency and diversification.9 The legal system’s reliance on possible differences in strategies and goals is arguably nothing more than a “red herring” intended to avoid addressing the cost-efficiency issue.

Actively managed funds and index funds clearly employ different approaches in managing their funds. However, if the courts focus on the bottom line, namely which funds best serve a plan’s participants best interests in terms of cost-efficiency, the “apples-to-apples” argument has no merit. One benefit of adopting a basic cost/benefit analysis is that is can be use to compare various types of investments based on their relative costs and returns.

In the case of the active/passive debate, each category has the same opportunity to prove its managements strategies are superior to the other fund’s strategies. The fact that actively managed funds typically charge higher fees and incur higher transaction costs obviously favors the odds of the index fund posting better cost/benefit performance numbers. However, actively managed funds could easily revise their management style and/or fees to become more competitive. Which leads to an obvious question – just how much active management do “actively” managed funds actually provide, and how much benefit do plan participants actually derive from such active management?

Sunlight Is the Best Disinfectant
In a 2007 speech, then SEC General Counsel Brian G. Cartwright posed that very question. Cartwright asked his audience to think of an investment in an actively managed mutual fund as a combination of two investments: a position in an “virtual” index fund designed to track the S&P 500 at a very low cost, and a position in a “virtual” hedge fund, taking long and short positions in various stocks. Added, together, the two virtual funds would yield the mutual fund’s real holdings.

The presence of the virtual hedge fund is, of course, why you chose active management. If there were zero holdings in the virtual hedge fund — no overweightings or underweightings — then you would have only an index fund. Indications from the academic literature suggest in many cases the virtual hedge fund is far smaller than the virtual index fund. Which means…investors in some of these … are paying the costs of active management but getting instead something that looks a lot like an overpriced index fund. So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether or not they’re getting the desired bang for their buck?10

A simple metric that I created, The Actively Management Value Ratio (AMVR), allows investors, plan sponsors, trustees and other investment fiduciaries to do just that. The AMVR allows anyone to quickly compare the relative cost-efficienccy of two mutual funds.

The AMVR is most often used to compare an actively managed mutual fund to a comparable index funds. The AMVR is based on the research of three investment experts. The initial version of the AMVR was based on the postions of two investment icons, Nobel laureate Dr, William F, Sharpe and Charles D, Ellis.

T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.11

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns.12

In version 3.0 of the AMVR, I added the concept of the Active Expense Ratio (AER). Professor Ross Miller essentially reiterated Cartwright’s concept of viewing actively managed mutual funds as consisting of two “virtual” funds. 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 index.13

I have written numerous posts examining the basic elements of the AMVR. You can easily find these posts by using the seach box provided on the right side of the web site.

In this post, I want to address the possible impact of combining the AMVR and the AER in 401(k) litigation going forward. I believe that SCOTUS may soon have an opportunity to decide whether the plan or the plan participants have the burden of proof on the issue of causation in such actions.

There is currently a split within the federal courts on that very issue. Those arguing that the plan participants bear the burden of proof point to the general rule that a plaintiff has to prove all elements of their case.14 Those arguing that the burden belongs to the plan sponsors point to the fact that the general rule has exceptions, one being in cases involving fiduciary relationships and the higher duties imposed on fiduciaries under the law.15

SCOTUS had an opportunity to decide this issue back in 2018 in connection with the Brotherston decision. The First Circuit Court of Appeals had ruled that a plan sponsor bears the burden of proof on causation, the burden of showing that any damages sustained by plan participants were not caused by the plan.16

SCOTUS invited the Solicitor General to file an amicus brief with the Court addressing the issue. The Solicitor General’s amicus brief stated that the burden of proof on causation in 401(k) litigation belongs to the plan sponsors.17 The Solicitor General based his opinion on (1) the fiduciary relationship between a plan sponsor and the plan participants, and (2) the fact that only the plan sponsor knows why they made the decisions they did and the processes they used. However, the Solicitor General ultimately recommended that the Court not grant certiorari to review the case since the action was still ongoing.

Combining the AMVR and the AER – Getting Down to the Nitty-Gritty
The AMVR is essentially the same cost-benefit technique taught in introductory economics classes. The simple question is whether the projected costs of the project exceed the project’s projected benefits. Most 401(k) cases are decided solely by a judge, the argument being that the cases are too complicated for the genral public to understand. In many cases, I beleive that argument is yet another “red herring” to avoid jury awards. Based on my experience with the AMVR, John and Jane Q. Public understand the simplicity of the AMVR, that investments whose projected costs exceed their projected benefits/return are not a prudent investment choice, and thus a breach of anmy fiduciary duties

Using the two “virtual” funds concept suggested by both Cartwright and Miller, the AMVR calculations show that I could receive a more cost-efficient risk-adjusted return of 11.42 percent from the index fund alone. In this case, the actively managed fund was a total waste of money, as it provided absolutely no benefit whatsoever. As the Uniform Prudent Investor Act states, wasting plan participants’ money is never prudent.18

The AER calculates both the implicit percent of active management provided by an actively managed fund, as well as the implicit cost of same using the r-squared score of the actively managed fund The first step in Miller’s metric is to calculates the Active Weight (AW) of the actively manged fund, the percentage of active management provided by the actively managed fund.

The r-squared of the actively managed fund shown in our example is 97. Miller uses the following equation to calculate an actively managed fund’s AW:

AW = SQRT(1 – r-squared)/[SQRT(1 – r-squared) + (SQRT (R-squared)]

Here, AW would equal .1487, or 14.87% (1.723/11.580)

To calculate an actively managed fund’s AER, you divide the incremental cost number from the AMVR calculations by the actively managed fund’s AW. In our example, the actively managed fund’s AER, its implicit expense ratio, would be calcuated by dividing the fund’s incremental cost (0.42) by its AW (0.1487), resulting in an implicit expense ratio of 2.82, as opposed to the fund’s stated expense ratio, .

Since we are using the two “virtual” funds approach in analyzing the actively managed fund, we need to add back the index fund’s stated expense ratio (.05), resulting in an AER of 2.87. approximately 5 times higher than the fund’s stated expense ratio. Remember, wasting plan participants’ money is never prudent.

There are various methods of interpreting the AMVR results. The AMVR slide shown above shows how the prudence/imprudence of an actively managed fund can quickly be determined by simply answering two questions.

(1) Does the actively managed mutual fund provide a positive incremental risk-adjusted return relative to the benchmark index fund being used?
(2) If so, does the actively managed fund’s positive incremental risk-adjusted return exceed the fund’s incremental r-squared-adjusted costs relative to the benchmark index fund?

If the answer to either of these questions is “no,” the actively managed fund is cost-inefficient and, thus, imprudent according to the Restatement’s prudence standards. The actively managed fund shown above should be quickly rejected.

Since the AMVR is essentially a cost/benefit analysis, the goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental adjusted return), but equal or less than “1” (indicating that the fund’s incremental adjusted costs did not exceed the fund’s incremental adjusted return).

As more plan sponsors, trustees, and other investment fiduciaries have adopted the AMVR metric as their fiduciary prudence standard, the one question that I have consistently received is why I added the AER at all. My response is always the same – trust me, there is definitely a method in the madness.

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….19

“Closet indexing” is a documented problem world-wide, Closet indexing raises important legal issues. Such funds are not just poor investments; they promise investors a service that they fail to provide. As such, some closet index funds may also run afoul of federal securities laws.20

While there is no universally agreed upon parameters for determing what constitutes closet indexing, the higher the level of correlation of returns, the stronger the argument for designation as a closet index fund. I personally believe that a correlation of 90 or above qualifies an actively managed fund as a closet index fund, especially when any incremental costs are considered. My postion is simply consistent with my position on the importance of cost-efficiency. Other groups use lower levels of correlation, even as low as 70.

Since research has shown that the overwhelming majority of actively managed mutual funds are cost-inefficient, unable to even cover their costs, the AER helps to expose possible closet index funds and avoid unnecessary fiduciary liability. For what it’s worth, ERISA plaintiff attorneys are increasingly incorporating the AER in their damages calculation in ERISA litigation.

Going Forward
2024 could prove to be a watershed year for both the 401(k)/403(b) industries and 401(k)/403(b) litigation. I believe that the odds are good that SCOTUS, if given the opportunity, will grant certiorari to review the Matney and/or the Home Depot 401(k) cases. My prediction is based primarily on the current split in the federal courts on the burden of proof in ERISA fiduciary cases, a split that is effectively denying employees in some sections of the country their rights and protections guaranteed under ERISA. Given the Court’s prior rulings in the Tibble21 and Northwestern22 cases, I believe that the Court would agree with the opinions of the Solicitor General, the DOL, several federal circuits, and the Restatement of Trusts and rule that the burden of proof as to causation in ERISA litigation properly belongs to the plan sponsor.

I believe that would result in increased 401(k)/403(b) litigation, not only between plan participants and plans, but also between plans and plan advisors. Plan sponsors often ask me what they can do to limit such liability and litigation exposure.

Unfortunately, I often have to advise them that due to the six-years statute of limitations that typically applies in 401(k) and 403(b) litigation, they can, and should, conduct a fiduciary prudence audit and immediately make any needed changes uncovered during the audit. While a prudence audit cannot retroactively limit any existing fiduciary liability exposure, it can proactively protect against such issues going forward.

What I am looking forward to seeing is how the financial service industry, both the securities and annuity sectors, address these issues. To date, the financial services industry has used a “preservation of choices” mantra. However, a cost-inefficient investment is not now, nor has ever been, a legitimate “choice.”

Yet another “red herring.” The AMVR can be used to provide the evidence to support such position. The AMVR can also provide a simple way to establish the monetary damages resulting from any breach of one’s fiduciary duties as a result of the inclusion of cost-inefficient actively managed funds within the plan.

As for the courts, hopefully the ERISA plaintiffs’ bar will address the continued unjustified and inequitable use of the “meaningful benchmarks” arguments to prematurely and inequitably dismiss meritorious 401(k) and 403(b) cases. While ERISA23 and other cases, most notably the First Circuit’s Brotherston decision, and various amicus briefs filed by the DOL24 and the Solicitor General25 have clearly established the validity of comparable index funds as legitimate comparators in ERISA litigation, the courts continue to ignore such arguments and authority.

Various reasons have been suggested for the refusal of some courts to recognize the fiduciary standards established by the Restatement and common law. Whatever those reasons may be, they do not justify either the denial of employees’ ERISA rights and the resulting, and possibly irreversible, harm being caused by the ongoing willful blindness of such courts.

One of my favorite sayings is from Aesop – “The tyrant will always find a pretext for his tyranny.” I have made several references to what I believe are pretexts that some courts are using to deny all employees a fair and equitable interpretation and protection of their rights under ERISA. ERISA is too important in helping employees work toward “retirement readiness” and their financial security to allow the current trend of dismissals of meritorious ERISA actions based on such pretexts.

The DOL’s recent amicus brief in the Home Depot 401(k) case made an interesting observation regarding some courts continuing reliance on the burden of proof on the causation issue to dismiss 401(k) and 403(b) actions. Citing the Second Circuit’s decision in the Sacerdote26 case, the DOL stated that

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.27

It is just that simple. Can anyone truthfully argue that a prudent fiduciary would select cost-inefficient mutual funds when more cost-efficient investment options are available? Hopefully, 2024 will be the year that SCOTUS finally has an opportunity to address that question and, in so doing, make ERISA meaningful for all employees.

Notes
1. See, e.g., Meiners v. Wells Fargo & Co., 898 F.3d 820, 823 (8th Cir. 2018)
Matney v, Barrick Gold of North America, No. 22-4045, September 6, 2023 (10th Circuit Court of Appeals. (Matney)
2. See, e.g., Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018). (Brotherston)
3. Tibble v. Edison International, 135 S. Ct 1823 (2015). (Tibble)
4. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
5. 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. 
6. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
7. Brotherston, Ibid.
8. Regulation Best Interest, Exchange Act Release 34-86031, 378, 380, 383-84 (2019).
9. 29 U.S.C.A. Section 404a; 29 C.F.R Section 2550.404a-1(a), (b)(i) and (b)(ii).
10. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What They Pay For?:The Legal Consequences of Closet Index Funds.” https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133 (Cremers), 5, 42.
11. William F. Sharpe, “The Arithmetic of Active Investing.” https://web.stanford.edu/~wfsharpe/art/active/active.htm.
12. 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
13. 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.
14. Matney, Ibid.
15. Brotherston, Ibid.
16. Brotherston, Ibid.
17. Amicus Brief of Solicitor General Noel Francisco in Brotherston v. Putnam Investments, LLC .(hereinafter “Brotherston Amicus Brief”), available at https://bit.ly/2Yp00xt
18. Uniform Prudent Investor Act, https://www.uniformlaws.org/viewdocument/final-act-108?CommunityKey=58f87d0a-3617-4635-a2af-9a4d02d119c9 (UPIA)
19. Cremers, Ibid.
20. Cremers, Ibid.
21. Tibble, Ibid.
22. Hughes v. Northwestern University, 595 U.S. 170 (2022).
23. RESTATEMENT (THIRD) TRUSTS, Section 100, comment b(1). American Law Institute. All rights reserved.
24. Amicus Brief of the Department of Labor in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022). (DOL Amicus Brief) http://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
25. Brotherston Amicus Brief, Ibid.
26. Sacerdote v. New York University, 9 F.4th 95 (2d Cir. 2021)
27. DOL Amicus Brief, 26.

Copyright InvestSense, LLC 2023. 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.

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The InvestSense Challenge for Plan Sponsors: Key Fiduciary Liability Risk Management Questions

Posted on December 4, 2023 by jwatkins

James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®

I often hear or read plan sponsors and other investment fiduciaries describing how hard their jobs are, how difficult it is to select and monitor their plan’s investment options and avoid fiduciary liability risk. After I perform a forensic fiduciary prudence audit, the company’s CEO or other corporate executives will often ask me what they did wrong and how to avoid unnecessary fiduciary liability exposure.

My ususal response is “you listened to the wrong people.” Now before all the plan advisers go ballistic, hear me out. There are experienced and knowledgable plan advisers who can genuinely help plan sponsors. The problem is that plan sponsors often do not know how to evaluate who those quality plan advisers are or how to “separate the wheat from the chaff.”

The other issue that plan sponsors must address is how to determine the quality of the advice that their plan adviser provides. Remember, plan sponsors can seek advice from third parties. However, plan sponsors cannot simply blindly rely on such advice.1 They must conduct their own independent investigation and evaluation of any third party advice.2 Failure to do so, or to do so incorrectly, is a violation of the fiduciary duties required under ERISA.3

In my experience, very few plan advisers provide any sort of fiduciary training to plan sponsors. My experience has generally been that any training provided often creates more questions than answers. I believe there are various reasons for this situation. The bottom line is that plan sponsors are often left with no ideas and no tools on to to conduct their legally required independent investigation and evaluation of potential plan investment options.

When I conduct a forensic fiduciary prudence audit, I conduct a simple fiduciary training sesssion to explain to the plan sponsor how I conduct my audit, explaining how they can use the same techniques in administering their plan. Since psychology shows that most people have both limited attention spans and retention skills, my training sessions typically consist of three common situations that plan sponsors typically encounter.

1. Which of the two mutual funds shown in the Active Management Value Ratio (AMVR) slide below is more cost-efficient and, thus, the more prudent investment choice for a fiduciary?

2.Which of the two mutual funds shown in the Active Management Value Ratio slide below is more cost-efficient and, thus, the more prudent investment choice for fiduciaries?

3. At what point would an investor breakeven/receive a commensurate return, i.e., would recover their initial investment, on a $100,000 annuity paying 4 percent annually? Note: This example assumes a “pure insurance” annuity investment.

Answers
1.

Nobel laureate Dr, William F. Sharpe of Stanford University has stated that the best way to evaluate actively managed funds is to compare the actively managed fund to a comparable index fund.4 While seconding Dr. Sharpe’s position, investment icon Charles D. Ellis has gone further, suggesting that the funds should be compared in terms of cost-efficiency by comparing the incremental costs and returns of the actrively managed fund relative to the index fund.5

Fund A, the Fidelity Contrafund Fund, K shares, is one of the most commonly offered mutual funds in U.S. defined contribution plans. The legal question is whether Contrafund’s K shares potentially expose a plan to unnecessary fiduciary liability exposure,

In this esample, Fund B, the Admiral shares of the Vanguard Large Cap Growth Index Fund, outperforms Contrafund’s K shares by 164 basis points (a basis point equals 1/100th of 1 percent, .01). Combined with Contrafund’s higher expense ratio (46 basis points), the cumulative 200 basis points would be projected to reduce a Contrafund’s end-return by 34 percent over a twenty year period.

Some courts take the position that you cannot compare actively managed mutual funds with comparable index funds. Not only is this position contrary to Section 100 of the Restatement (Third) of Trusts, but it is inconsistent with the stated purpose and goal of ERISA, to protect employees and promote cost-conscious saving towards retirement.

People often ask me what the “AER” column represents. “AER” stands for Ross Miller’s metric, the Active Management Value Ratio. Miller explains the value of the metric as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.6

The AER calculates the implicit cost of any incremental, or additional, costs of an actively managed mutual fund to evaluate the active fund’s relative cost-efficiency, i.e., prudence. In this case, the Contrafund investor would pay an additional 42 basis points without receciving any corresponding benefit. As Section 7 of the Uniform Prudent Investor Act states, wasting beneficiaries’ money is never prudent.7

2.

This slide is included in my fiduciary prudence training session for two reasons. First, to remind plan sponsors of the need to compare all investment recommendations of a fund family with other similar funds within the fund family. In this case, Fidelity has a much more prudent investment option in the same large cap growth category.

Fidelity actually created this LCG fund to compete with Vanguard’s LCG fund. The expense ratio of the Fidelity LCG fund was designed to undercut Vanguard’s low expense ratio. The fund’s performance has also been competitive, in some cases slightly better, than Vanguard’s comparable fund.

Second, the slide illustrates the need for plan sponsors to effectively negotiate for more prudent options within a fund family. When I see Fidelity Contrafund K shares in a plan, I point out the existence of the Fidelity LCG fund. Plan sponsors often note that Fidelity does not offer the LCG fund to 401(k) and 403(b) plans.

However, the key point is that plan sponsors cannot simply settle for a less prudent option when a more prudent option exists within a fund family. Fidelity may be concerned that offering the obviously more prudent LCG fund would result in the cannibalization of the Contrafund K shares. That’s their right and a legitimate concern.

However, in such situations, I believe that a plan sponsor’s fiduciary duties require the plan sponsor to seek alternative investments that comply with their fiduciary duties, whether those alternatives be within the same fund family or another fund family. Bottom line – plan sponsors, and investment fiduciaries in general, cannot “settle” for legally imprudent investments.

In this case, the combined costs, Contrafund’s relative underperformance/opportunity costs (267 basis points), combined with the incremental expense ratio costs (approximately 43 basis points), would project to a 46 percent reduction in an investor’s end-return over a 20-year period (271 basis point times 17).

The simplicity of the AMVR metric has proven to be very well received by both judges and juries. Plan sponsors and other investment fiduciaries who are willing to invest the small amount of time needed to learn the AMVR calculation process will be justly rewarded.

3. In this illustration, the an 65-year-old annuity owner would have to live past age 100 in order to simply break even if the owner chose a single life payout option.

Annuity advocates may object to this “pure insurance” forensic acturial analysis based on the factors of present value and mortality risk. However, the target audience of both this post and this blog is plann sponsors and other investment fiduciaries . The purpose of this particular illustration is to alert plan sponsors of the need to demand information that will alert them to possible issues that they need to consider in performing their legally required independent investigation and evaluation, should they consider offering annuities within their plan in any form, individually or as part of target date funds.

Given the potentially large accounts within 401(k) and 403(b) plans, the annuity industry has consistently tried to gain access to plan participants in order to convince them to invest in various forms of annuities. However, several annuity experts, including annuity industry executives, have noted the inherent inequities in many annuities.8

As a fiduciary risk management counsel, I have adopted a very simple fiduciary prudence process for evaluating investment products, including annuities:

1. Does ERISA expressly require that a plan sponsor offer the specific product be offered within a plan? ERISA Section 404(a) states as follows:

(a) Prudent man standard of care

(1)[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;9

Note the absence of any specific mention of annuities, or any other specific type of investment.

2. Would/Could inclusion of the specific product being considered potentially expose the plan and plan sponsor to the risk of unnecessary fiduciary liability?

Prudent plan sponsors do not expose themselves to the risk of unnecessary fiduciary risk. Since ERISA does not expressly require that annuities be offered within a pension plan and annuities present genuine and unnecessary fiduciary risk, I advise my fiduciary risk management clients to avoid annuities altogether. Plan participants who wish to purchase an annuity are obviously free to do so outside the plan.

Based upon my 40+ years of experience, I firmly believe that most plan sponsors, and investment fiduciries in general, needlessly expose themselves to fiduciary breach actions simply because they do not take the time to review valuable resources, such as the Restatement (Third) of Trusts and relevant academic studies which discuss the numerous inherent fiduciary risks associated with annuities. I have written several posts on the inherent fiduciary prudence and fiduciary liability concerns with reagrd to annuities, including my most recent posts here and here.

Legal precedent and current legal decisions are taking on increased importance in designing and maintaining ERISA compliant pension plans. Two current 401(k) fiduciary breach actions, the Matney and Home Depot cases, could dramatically change the current 401(k) and 403(b) fiduciary liability industry. Many ERISA plans are recognizing the value of retaining experienced and knowledgable ERISA counsel to provide fiduciary oversight services as a form of fiduciary liability insurance.

Fixed indeed annuities (FIAs) are the subject of a recent Department of Labor proposal. As mentioned earlier, the annuity indusry has consistently attempted to gain access to pension accounts. The latest strategy is to market indexed annuities as an opportunity to earn higher returns than traditional fixed annuity returns by investing in market indices such as the S&P 500. These higher returns can be converted into “guaranteed income for life.”

As a plaintiff’s attorney for most of my legal career, as well as a former compliance director, I am always interested in “reading between the lines” of contracts and business opportunities to see what’s not being said, looking for potential misrepresentations and other questionable marketing practices.

As a securities complaince director, I could, and still can, see “complaint” written all over indexed annuities due to their complexity and the resulting confusion given the technicalities involved with indexed annuities, including how earned interest is credited to such annuities; the cumulative impact of provisions such as spreads, cap rates and participation rates; and the fact that fixed annuity issuers often reserve the right to change such key terms annually.

Will Rogers’ famous line was that he was not so much worried about the return on his investment as he was on the return of his investment. Will Rogers no doubt would have disliked annuities. Annuity advocates like to repeat the “guaranteed income for life” mantra. As a plaintiff’s attorney, I notice that the annuity issuer does not guarantee a commensurate return, a return of the annuity owner’s principal to breakeven, but rather simply a guarantee of some income for life. This raises several potential issues for plan sponsors and other investment fiduciaries.

This is why I always advise my fiduciary clients, and investors in general, to always require that the agent/broker provide them with a written breakeven analysis. More often than not, a properly prepared breakeven analysis will show that the odds are against an annuity owner even breaking even on their investment. This is due to actuarial concepts such as factoring in both the concept of the present value of money and an owner’s mortality risk, the risk that they will even be alive to receive an annual annuity payment.

The illustration shown is a “pure insurance” breakeven analysis on a $100,000 annuity paying 4 percent interest annually. FIA advocates often object to such breakeven analyses, saying that they do not factor in investment returns.

They have a point. I would argue that their point proves my point in terms of the fiduciary imprudence of annuities in general. At the same time, most plan sponsors will need some supporting doumentation that they can use to (1) meet their personal fiducairy duties to independently investigate and evaluate a plan’s investment options, and (2) fulfill their legal obligation to provide plan participants with “sufficient information to make an informed decision” in order to qualify for the extra liability protection available under ERISA Section 404(c).

In cases where an agent/broker refuses to provide a written breakeven analysis, plan sponsors should always require that they be provided with a written comaprative analysis of the annuity’s relative performance against a comparable market index over sample time periods, e.g., 10 years 20 years, similar to the same performance disclosures currently required for actively managed mutual funds.

Interestingly enough, MassMutual conducted a study shortly after the indexed annuities concept was introduced. They compared a hypothetical indexed annuity with the performance of the S&P 500 index, both with and without dividends, over a thirty year time period. They found that the hypothetical indexed annuity underperformed both versions of the S&P 500 during the time period, with the annuity underperforming the S&P 500 without dividends by approximately 32 percent, and underpeforming the S&P 500 with dividends by approximately 52 percent. They also discovered that over the same time period, even a simple investment in Treasury bond would have outperformed the hypothetical annuity.10

I have argued that empirical evidence similar to the MassMutual study is admissable in cases involving fixed indexed annuities given the fact that indexed annuity issuers often reserve the right to unilaterally change key terms of the annuity annually, terms that directly impact an annuity owner’s end-return.
As a result of this right to annually change the key terms of the annuity, I maintain that indexed annuities are analogous to an actively managed mutual fund.

Based on this analogy, I beleive the fiduciary prudence standards established under the Restatement (Third) of Trusts should be equally applicable in determining the fiduciary prudence of a FIA. Section 90, comment h(2) of the Restatement states that in connection with actively managed investments, it is imprudent to use active management strategies and/or actively managed funds unless it can be ojectively predicted that the active management strategy/fund will provide a commensurate return for the extra costs and risk assumed by an investor.

The odds are against an indexed annuity being able to carry that burden of proof. As Dr. William Reichstein of Baylor University has pointed out, the design of indexed annuities guarantees that an indexed annuity will underperform a comparable benchmark composed of high-grade bonds and options by an amount equal to the combined cost of the annuity’s spread and transaction costs.11

Going Forward
My role as a fiduciary risk management counsel is to alert plan sponsors and other investment fiduciaries as to actual and potential fiduciary liability “traps” and available methods of proactively exposing and avoiding such “traps.” As mentioned earlier, two pending 401(k) actions, the Matney and Home Depot cases, could result in greater fiduciary risk for plan sponsors going forward.

When I speak with plan sponsors about the AMVR metric, as well as the value of forensic fiduciary prudence audits and fiduciary oversight services, the responses are typically along the lines of shrugging the issues off or, even worst, indicating an intent to claim ignorance of the applicable laws and requirements. To plan sponsors planning to use the latter, just remember that judges and regulators like to remind plan spsonsors and other investment fiduciaries that when it comes to alleged breaches of one’s fiducairy duties, “a pure heart and an empty head” are no defense to such claims.

Notes
1. Liss v. Smith, 991 F. Supp. 278, 299.
2. Fink v. National Savs. & Trust Co., 772 F.2d 951, 957, 962 (Scalia dissent) (D.C. Cir. 1985). (Fink)
3. The failure to make any independent investigation and evaluation of a potential plan investment is a breach of fiduciary obligations. Fink, (Fink), In re Enron Corp. Securities, Derivative “ERISA“, 284 F.Supp.2d 511, 549-550, Donovan v. Cunningham, 716 F.2d at 1467.52
4. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
5. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
6. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49.
7.Uniform Prudent Investor Act, https://www.uniformlaws.org/viewdocument/final-act-108?CommunityKey=58f87d0a-3617-4635-a2af-9a4d02d119c9 (UPIA)
8. Milevsky, M. &  Posner, S., “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.; Johns, J. D., “The Case for Change,” Financial Planning, 158-168, 158 Johns, J. D. (September 2004);  Reichenstein, W., “Financial analysis of equity indexed annuities.” Financial Services Review, 18, 291-311, 291 (2009); Reichenstein, W., “Can annuities offer competitive returns?” Journal of Financial Planning, 24, 36 (August 2011) (Reichenstein)
9. 29 C.F.R. § 2550.404(a)-1; 29 U.S.C. § 1104(a).
10. Jonathan Clements, “Why Big Issuers Are Staying Away From This Year’s Hottest Investment Products,” Wall Street Journal, December 14, 2005, D1. 
11. Reichenstein.

Copyright InvestSense, LLC 2023. 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.

Posted in 401k, 401k compliance, 401k investments, 401k litigation, 401k plan design, 401k plans, 401k risk management, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, Annuities, compliance, consumer protection, cost consciousness, cost efficient, Cost_Efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, financial planning, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement planning, retirement plans, RIA, RIA Compliance, risk management, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , | Leave a comment

“Knew or Should Have Known: Annuities, Plan Sponsors, and Fiduciary Law – Part 2

Posted on October 31, 2023 by jwatkins

James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®

In Part 1 of “Knew or Should Have Known”: Annuities, Plan Sponsors, and Fiduciary Law,” I examined the basic structure of fiduciary law and some of the potential fiduciary liability issues posed by the inclusion of annuities within 401(k) and 403(b) plans. In this post, I want to address some of the key issues that plans sponsors and other investment fiduciaries should consider during the course of their required fiduciary investigations and evaluations.

Annuities are complex investments. During both my compliance and legal careers, I have been fortunate enough to have had three annuity experts that I knew that I could trust implicitly – Peter Katt, John Olsen, and  most recently, Chris Tobe. Chris is one of the co-founders of the CommonSense 401(k) Fiduciary Project (commonsense401kproject.com). I highly recommend that anyone interested in potential fiduciary liability issues posed by annuities visit the Project’s web site and read Chris’ posts.

Sadly, Katt passed away in 2015. Fortunately, his informative articles are still available online.

John and I actually exchanged emails this past weekend as I was preparing to write this post. John is an incredible resource on annuities and is available for consulting work via LinkedIn (JohnOlsen CLU, ChFC, AEP) or through his company, Olsen Annuity Education.

I contacted John to let him know that I intended to reference his excellent article on indexed annuities, “Index Annuities: Looking Under the Hood.”1 John has always had an incredible ability to simplify the complexity of annuities. I highly recommend that any investment fiduciary considering including annuities in ERISA plans, or continuing to offer annuities within their plan, contact John.

Annuities, Fundamental Fairness, and Fiduciary Liability
I want to discuss a couple of John’s more significant points in terms of understanding annuities, especially with regard to potential fiduciary liability issues for plan sponsors and other investment fiduciaries.

As a compliance director, one of my concerns was with regard to the marketing strategies used by the index annuity issuers, specifically the potentially misleading reference to market returns. Typically, the return on such market indexed annuities is based on the performance of an underlying market index, such as the S&P 500 Index.

However, as John points out, indexed annuities typically contain various “moving parts” which limit the actual return received by indexed annuity owners.

It is not simply a matter of if the index increases by 10 percent, the annuity owner gets 10 percent interest. Rather, that interest is based on the index growth, modified by one or more contract features that are often called moving parts.2

If an index has declined, zero current interest is credited with respect to that index for the crediting period. If an index value has risen, the amount of that gain is noted, and one or more moving parts are applied to determine the portion of that gain that will be declared as current interest to be credited in accordance with the contract language.3

The spread is the percentage of index gain that will not be credited as interest, the first few percent off the top, so to speak. For example, if the spread (i.e., margin or fee) is 3 percent, then only gain in the index in excess of that percentage will be credited. Given the spread of 3 percent, a 10 percent index gain would produce 7 percent interest credited to the annuity (assuming a 100 percent participation rate).4

Cap rates and participation rates are two commonly used means by which annuity issuers can further resrict the actual gain realized by an annuity owner. As John points out, there are actually two types of cap rates – one that limits the amount of the index gain that will be recognized in calculating the interest to be credited to the annuity owner; the other cap being a limitation on the amount of the indexed-linked interest that will be crediteed to the annuity owner

Using the example above, if the annuity imposed an annual cap rate of 6 percent, the annuity owner would only be credited with 6 percent of the original 10 percent gain. If the annuity issuer also imposed a participation rate of 70 percent, the annuity owner’s realized return would be further reduced to just 4.2 percent.

Only 4.8 percent on the original 10 percent gain. Remember, fiduciary law focuses primarily on fundamental fairness.

John also addresses a common mantra used by annuity advocates, that investors cannot lose money in an indexed annuity. Lack of liquidity is one of the often cited drawbacks of annuities. If an annuity owner needs to withdraw money from an annuity, such withdrawal will typically result in a surrender charge. John notes that such surrender charges may actually result in a loss of an annuity investor’s premium:

While some contracts have a genuine guarantee of principal (surrender charges may wipe out interest earned but not the money contributed in premiums) that preserves premium even in the early contract years, most do not.5

This possible lost of premiums paid is clearly inconsistent with the annuity industry’s mantra that you can never lose money in an annuity. However, to be fair, negative performance of the base index in one year does not reduce the accumulated credit in the annuity.

One final point addressed by John has to do with the fact that annuity issuers often reserve the right to change the value of the annuity’s cap rate and/or participation rate. During my compliance director days, this was the subject of some intense discussions in the compliance department, as some annuity issuers will offer “teaser” rates to entice investors to purchase an annuity, with the annuity issuer knowing that they intend to significantly reduce the actual interest rate almost immediately. “Annuities are sold, not bought,” is a well-known saying in the financial services industry…and for good reason.

The fact that annuity issuers typically reserve the right to change cap and/or participation rates has potentially serious fiduciary liability implications for plan sponsors and other investment fiduciaries. As I have successfully argued, this is clearly a material fact that a plan sponsor knows or should know as a result of the plan sponsor’s required investigation and evaluation. The law defines “material fact” as

[A] fact that a reasonable person would recognize as relevant to a decision to be made, as distinguished from an insignificant, trivial, or unimportant detail. In other words, it is a fact, the suppression of which would reasonably result in a different decision.6

The annuity owner’s right to unilaterally change the rules for their benefit and significantly reduce the annuity owner’s realized return is clearly inconsistent with the “fundamental fairness” principles of fiduciary law. While the annuity industry tries to justify this right as necessary for the annuity industry, the practice and its impact on plan participants should automatically preclude any consideration of such an annuity in any ERISA plan.

John’s article addresses an additional concern that fiduciaries should consider in deciding on whether to include annuities which reserve the right to unilaterally change the terms of the annuity to protect its interests over those of an annuity owner – the potential ability of the annuity owner to manipulate an annuity’s cap rates and/or participation rates to increase the annuity issuer’s return at the expense of the plan participants who purchase such annuities.

It is possible, of course, that an insurer will set participation and cap rates on its contracts lower than necessary, in order to retain more of the index gain itself, but an insurance company that does that will quickly find its products uncompetitive.7

Annuity advocates become annoyed when I respond to their arguments by simply pointing out that ERISA does not require a plan to offer annuities within a plan. Therefore, given the risk of exposur to unnecessary fiducairy liability, why go there? As I tell my fiduciary clients, a prudent investment fiduciary does not voluntarily expose themselves to the risk of unnecessary fiduciary liability. Plan participants desiring to purchase an annuity are obviously free to do so outside of their plan, without exposing the plan sponsor to concerns about fiduciary liability exposure.

Annuities and Fundamental Fairness/Commensurate Return
Insurance companies typically condition settlement of a civil case with significant damages on the plaintiff’s willingness to agree to the use an annuity in paying damages. The young and/or inexperienced plaintiff’s attorney may then communicate to their client that the insurance company has offered to settle the case for a million dollars.

The client agrees to accept the offer of a million dollars, only to learn later that the present value of the annuity offered is much less than a million dollars, perhaps 70-80 percent less. The difference in present value of the annuity is due to the time value of money factor. In short, a dollar due in 10-20 years is worth much less that a dollar received today.

The Restatement of Trusts (Restatement) is a valuable resource for investment fiduciaries. Even the Supreme Court has acknowledged the value of the Restatement in resolving issues involving fiduciary law.8

As a plaintiff’s attorney, I had to learn how to apply actuarial methods to evaluate offers involving annuities, as defense attorneys and insurance companies are typically defiant when questioned about the present value of a proposed annuity in a settlement. Most courts no longer tolerate such tactics and value the settlement offer based upon the actual cost that the insurance company will incur in purchasing the subject annuity. Judges have little patience with attorneys who prevent the court from controlling the court’s case load.

In a recent post, I posted the results of a hypothetical forensic breakeven analysis of an annuity using common actuarial tables and calculations. The results exposed a common issue that plan sponsors and other investment fiduciaries must consider – the fact that in many, if not most, cases, annuity contracts are drafted in such a way to ensure that the odds favor the annuity issuer’s interests over the interests of the annuity owner, resulting in a windfall in favor of the annuity issuer.

“Equity abhors a windfall” is a basic tenet of both equity and fiduclary law. With regard to 401(k) and 403(b) plans, fiduciary law demands that the best interests of the plan participants and their beneficiaries are always paramount. One of my favor fiduciary mantras is that “there are no mulligans in fiduciary law.” For non-golfers, that equates to “there are no do-ovewrs in fiduciary law.”

After I posted my actuarial hypothetical, people accused me of “cherry-picking” my facts to support my position. The again, a retired actuary told me that my analysis was sound.

However, I decided to run some additional scenarios with different assumed interest rates for future presentations. I ran the forensic actuarial analysis using interest rates of 5 percent and 6 percent, again based on both present value alone and present value plus mortality factors. The chart below shows the results of my forensic actuarial analyses based on a 65 year-old client purchasing a $250,000 annuity at the indicated interest rate.

Interest RatePV @ Age 100PV+M @ Age 100
4%$189,465$137,756
5%$236,832$172,196
6%$284,198$206,635

If we assume that fiduciary prudence requires that an annuity provide an annuity owner with a realistic opportunity to receive a commensurate return, an opportunity to at least breakeven, the chart shows that using the annuity’s present value alone only provides a commensurate at a 6 percent interest rate. The approximate breakeven point in such case would be $250,520 at age 94

If we analyze the same annuity using both present value and discount for a mortality factor, each annuity fails to provide a commensurate return at all three interest rates. Courts typically require that annuities be analyzed in terms of both present value and a mortality factor.

This type of actuarial analysis is essential in analyzing potential liability issues and is applicable to any type of annnuity involving a series of future payments. My concern is that most plan sponsors are unaware of the importance of such analyses with regard to fiduciary prudence and loyalty, much less being able to perform and/or interpret such analyses. As a result, a plan sponsor could be unnecessarily exposing themselves to unwanted and indefensible fiduciary liability.

Annuities are essentially bets, the annuity issuer betting that the annuity owner will not live long enough to break even, which would result in the annuity owner receiving a windfall equal to the remaining balance in the annuity at the annuity owner’s death. As discussed earlier, the annuity issuer could then place such funds in a so-called “mortality pool,” an account that an annuity owner can use to help cover their legal obligations to other annuity owners.

Remember – “Equity abhors a windfall.”

Going Forward
In these two posts, I have focused on what I have taught my fiduciary risk management clients and attorneys on what I believe the major opportunities will in litigating fiduciary breach actions involving annuities. Each of the identified issues can be simplified in terms of (1) breaches of fundamental fairness, and (2) plan sponsors involving themselves in actions/choices which they are not required to be involved in under either ERISA or basic fiduciary law, my “why go there” mantra.

The various fiduciary prudence and loyalty issues discussed herein are all issues that a plan sponsor should consider in deciding whether to offer annuities with their plan. Should a plan sponsor decide to offer annuities within their plan, the plan sponsor should be prepared to defend their decision in court by showing that factoring all the issues discussed herein, a prudent would have made the same decision.

Most plan sponsors desire to receive the extra liability protections provided by ERISA Section 404(c). Plan sponsors seeking such extra protection will have to address and resolve is how to coimply with Section 404(c)’s requirement that a plan sponsor has to provide “sufficient information to allow a plan participant to make an informed decision.”

While we discussed several fiduciary issues that would arguably constitute material facts which would need ro be provided to plan participants, we did not discuss arguably the most complicated and confusing aspect of indexed annuities, that being the various methods used by annuity issuers in calculating the interest to be credited to an annuity issuer.

John does a good job in discussing the various calculation methods used. I will leave it at that and wish the readers good luck in trying to understand the various calculation methods used.

Tomorrow, October 31, 2023, the DOL is scheduled to release its new Retirement Security regulation. The 10th Circuit Court of Appeals recently handed down a decision in the Matney case9, a decision that I believe will be vacated if reviewed by SCOTUS due to the Court’s erroneous interpretation of the application of revenue sharing. A decision in the Home Depot 401(k) action10 is currently pending in the 11th Circuit Court of Appeals, the key issue being the same as was presented in the Matney case, namely which party has the burden of proof on the issue of causation in 401(k)/403(b) fiduciary breach actions.

I am often asked whether I could envision any situation where an annuity might be a prudent investment option under fiduciary law. My response is always the same:

Unless and until the annuity industry recognizes the legitimacy of the fiduciary liability issues involved with annuities and guarantees a plan participant a commensurate return for the extra risks and costs associated with annuities, annuities will continue to be a fiduciary liability trap. When it comes to providing a commensurate return, it is not a question of the annuity issuer’s ability to do so, but rather the profitability of doing so.

I suggest that plan sponsors and other investment fiduciaries seriously consider the message in that last sentence as it pertains to potential fiduciary liability situations. Going forward, plan sponsors can anticipate increasing litigation involving the issue of breaches of the fiduciary duties of prudence and loyalty.

The issue is not, and never has been, about the value of retirement income. The issue is about the fundamental fairness of the investment vehickle offering the additional retirment income. For fiduciaries, the question is, and always has to be about commensurate return for any extra costs and risks associated with viable investment alternatives, about cost-consciousness and the relative cost-efficiency of each investment alternative under consideration.12

Plan sponsors ultimately deciding to offer annuities within their plan should be prepared to justify their decision in terms of each of the issues discussed herein and other “fundamental fairness” issues, especially when compared to other viable and more transparent alternatives such as certificates of deposit, and various types of bonds, e.g., investment-grade corporate bonds, U.S. government bonds, municipal bonds. “Humble Arithmetic,” common sense, and current fiduciary law suggests that that will be a significant hurdle to clear, especially with new regulations and legal decisions on the horizon.

Remember this truism – Prudent plan sponsors do not voluntarily expose themselves to the risk of unnecessary fiduciary liability.

Notes
1. John Olsen, “Index Annuities: Looking Under the Hood,” Journal of Financial Service Professionals, 65-73 (November 2017). (Olsen)
2. Olsen, 66.
3. Olsen, 66.
4. Olsen, 66.
5. Olsen, 72.
6. https://en.wikipedia.org/wiki/Material_fact
7. Olsen, 72-73.
8. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
9. Matney v, Barrick Gold of North America, No. 22-4045, September 6, 2023 (10th Cir. 2023.
11. Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022).
12. See Restatement (Third) Trusts, Section 90 (The Prudent Investor Rule), comments b, f, and h(2).

Copyright InvestSense, LLC 2023. 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.

Posted in 401k, 401k compliance, 401k investments, 401k litigation, 401k plan design, 401k plans, 401k risk management, 403b, 404c, 404c compliance, Active Management Value Ratio, Annuities, compliance, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investment advisers, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, risk management, SCOTUS, Supreme Court, wealth management | Tagged , , , , , , , , , , , , , , , | Leave a comment

“Knew or Should Have Known”: Annuities, Plan Sponsors, and Fiduciary Law – Part 1

Posted on October 29, 2023 by jwatkins

James W. Watkins, III, J.D., CFP EmeritusTM, AWMA®

For years, the annuity industry has attempted to gain greater access to plan participants’ accounts within 401(k) and 403(b) retirement plans. The industry has tried to counter the fiduciary prohibition against the receipt of commissions with versions of annuities that do not pay commissions to fiduciaries. Furthermore, the industry recently lobbied Congress to provide plan sponsors further incentives to offer annuities within plans. The SECURE Act provides a potential safe harbor against fiduciary liability for plan sponsors offering annuities within their plans in the event that the annuity issuer is subsequently unable to honor its legal obligations to plan participants. Protection for the plan sponsors, but not for the plan participants.

What the annuity industry either does not know or knows but refuses to acknowledge, aka “willful ingnorance,” is that there are other significant potential liability issues with annuities that investment fiduciaries should be aware of, issues that, left unaddressed, effectively make most annuities potential fiduciary liability traps for plan sponsors and other investment fiduciaries.

I previously addressed a number of legal issues that potentially make annuities fiduciary liability traps for plan sponsors in an earlier post, The post generated, and continues to generate, inquiries from plan sponsors and other investment fiduciaries on both fiduciary risk management vis-a-vis annuities and the topic of fiduciary risk management in general.

What concerns me is that I see disturbing situations developing in the annuity industry’s campaign to offer more annuity products within pension plans. My experience has been that plan sponsors often do not truly understand their legal obligations as fiduciaries, what is and is not required of them. Given the financial services industry’s and the insurance/annuity industry’s adamant opposition to meaningful transparency, plan sponsors should have no expectation of same from such industries.

For example, both industries relentlessly publish studies and related articles stating that polls claim that plan participants are interested in products offering “guaranteed income” and promoting “retirement readiness,” “financial wellness,” or another buzzword. Such industry articles should have no influence on a prudent plan sponsor.

Neither ERISA, the Restatement of Trusts (Restatement), nor the common law of trusts requires that a plan sponsor, or any other investment fiducairy for that matter, offer a specified type of investment. The three sources cited only require that the plan sponsor only offer investment options that are legally prudent, investment products that are truly in the best interest of the plan participants.

And yet, most plan sponsors do not understand that fact since most have never read either ERISA and/or the Restatement or consulted with an ERISA attorney. As a result, they can be easily misled, whether intentionally or unintentionally, to engage in unnecessary activity that is not required of them and toward goals they cannot possibly achieve, activity that can actually result in unnecessary and unwanted fiduciary liability exposure.

As a fiduciary risk management counsel, my job is to explain the potential fiduciary liability pitfalls to plan sponsors in order to avoid unnecessary liability exposure. In my presensentations, I focus on three areas: (1) a plan sponsor’s duty to independently and objectively investigate and evaluate each investment option within a plan, (2) a plan sponsor’s actual fiduciary duties under ERISA Section 404(a) to know and factor in the the material facts discovered as a result of performing their legally required investigation and evaluation, and (3) ERISA Section 404(c)’s “adequate information to make an informed decision” requirement for Section 404(c)’s safe harbor protection.

The first thing I tell my fiduciary risk management clients is not to worry about getting sued. Anyone who can pay the necessary filing fees can sue anyone they want. My value proposition to my clients is the ability to review their plan in terms of legal compliance to ensure that their plan is properly designed and maintained so that if they do get sued, they should not lose the case. Those are the issues that investment fiduciaries should focus on.

I created the following diagram to help my fiduciary risk management clients understand the basic legal liability issues involved in fiduciary law.

Fiduciary law is essentially a combination of three types of law – trust law, agency law, and equity law. Trust law and agency law track each other in many ways since they deal with duties owed by a fiduciary representing the legal interests of their beneficiaries (trust law) and/or principals (agency law).

Two key fiduciary duties are the duties of prudence and loyalty. Borrowing from both the common law of trusts and the Restatement of Trusts, ERISA describes the duties of prudence and loyalty as follows:

[A] fiduciary shall discharge that person’s duties with respect to the plan solely in the interests of the participants and beneficiaries; for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the plan; and with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.1

With regard to the consideration of an investment or investment course of action taken by a fiduciary of an employee benefit plan, the requirements of section 404(a)(1)(B) of the Act are satisfied if the fiduciary:

(i) Has given appropriate consideration to those facts and circumstances that, given the scope of such fiduciary’s investment duties, the fiduciary knows or should know are relevant to the particular investment or investment course of action involved, including the role the investment or investment course of action plays in that portion of the plan’s investment portfolio or menu with respect to which the fiduciary has investment duties; and
(ii) Has acted accordingly.2 (emphasis added)

(2) For purposes of paragraph (b)(1) of this section, “appropriate consideration” shall include, but is not necessarily limited to:

(i) A determination by the fiduciary that the particular investment or investment course of action is reasonably designed, as part of the portfolio (or, where applicable, that portion of the plan portfolio with respect to which the fiduciary has investment duties) or menu, to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action compared to the opportunity for gain (or other return) associated with reasonably available alternatives with similar risks;3 (emphasis added)

Fiduciary prudence focuses on the process used by a plan sponsor in investigating and evaluating the investment products chosen for a plan, not the eventual performance of the product. In assessing the process used by a plan sponsor, the courts evaluate prudence in terms of both procedural and substantive prudence.

Procedural prudence focuses on whether the fiduciary utilized appropriate methods to investigate and evaluate the merits of a particular investment. Substantive prudence focuses on whether the fiduciary took the information from the investigation and made the same decision that a prudent fiduciary would have made. Note the requirement is would have made, not could have made.

Fiduciary Duty to Conduct Independent Investigation and Evaluation
The courts have consistently held that plans have a fiduciay 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.4

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard. (citing Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983); Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981). 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.5 (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 perfrom 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”6

[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.7 

In conducting their investigations and evaluations, plan sponsors considering offering annuities within their plan should especially note the “knows or should know” language. 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 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.8

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.9

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 thrity year period.

Equity and Fiduciary Law
The cornerstone of equity law is fair dealing/fundamental fairness. A well-known tenet of equity law is that “equity abhors a windfall,” a situation where one party derives an unfair benefit at the expense of another.

I believe that the windfall issues with annuities has not received enough attention with regard to potential fiduciary liability exposure. My opinion is based on the fact that annuities are generally designed to increase the odds that annuity issuers ultimately receive a windfall in most cases, a windfall that they can use help them cover legal liabilities owed to other annuity owners via a so-called “mortality pool.”.

Courts in 401(k)/403(b) litigations often dismiss breach of loyalty claims on the grounds that the plan sponsor did not directly benefit from the investment options chosen for a plan. The annuity industry often makes similar claims. However, it can be argued that a breach of loyalty under fiduciary law also includes any situation where the plan sponsor’s decision benefits a third party at the expense of a plan participant who invests in an annuity offered within the plan.

The “Comments” section under Section 5 of the Uniform Investor Act10, “Loyalty,” states as follows:

The duty of loyalty is perhaps the most characteristic rule of trust law, requiring the trustee to act exclusively for the beneficiaries, as opposed to acting for the trustee’s own interest or that of third parties.11

A fiduciary cannot be prudent in the conduct of investment functions if the fiduciary is sacrificing the interests of the beneficiaries.12

The duty of loyalty is not limited to settings entailing self-dealing or conflict of interest in which the trustee would benefit personally from the trust.13

The trustee is under a duty to the beneficiary in administering the trust no to be guided by the interest of any third person.14

In my legal cases and in presentations to investment fiduciaries, I often use the following example:

Would you be interested in a product that can offer you guaranteed income for life? The only requirement to receive that lifetime stream of income is that you will have to surrender both control of the product and the accumulated value within the product to the company offering the product, with the issuer being allowed to unilaterally change the interest rate on the annuity at any time, with no guarantee that annuity owner will receive a commensurate return in exchange for surrendering both the value and control of the annuity, and with the understanding that the issuer, not your heirs, will receive any residual value in your account when you die.

Annuity advocates will often point out that annuities often offer so-called “riders” that do guarantee a return of the annuity owner’s principal to the annuity owner’s heirs…for an additional price. With annual fees within an annuity often running two percent or more, the additional fee for “riders” serves to further reduce an annuity owner’s payments under the annuity.

As both the Department of Labor and the federal General Accountability Office have pointed out, each additional one percent in fees and expenses reduces an investor’s end-return by approximately 17 percent over a twenty-year period.15 Riders often cost an additional one percent or more of the annuity’s accumulated value. When combined with an annuity’s other annual costs, it is easy to see how over half of an annuity owner’s end-return can be lost in an annuity’s annual fees (3 times 17).

When people ask me to define fiduciary law in 5 words or less, my answer is simple – fundamental fairness. Looking at the sample disclosure above, a prudent investment fiduciary should quickly determine that the annuity is heavily weighted in favor of the annuity issuer, not the anuity owner. That is why I argue that annuities are imprudent under applicable fiduciary principles/laws and are, ipso facto, fiduciary liability traps. (Sorry, someone dared me to use the term in exchange for a donation to St. Jude Children’s Hospital.)

In part two of this post, we will discuss ERISA section 404(c)’s “sufficient information to make an informed decision” issues relative to annuities and sufficient fiduciary disclosures, as well as a possible model that plan sponsors can use to decide whether annuities belong in their 401(k)/403(b) plan at all.

Notes
1. 29 U.S.C.A. Section 404a
2. 29 C.F.R Section 2550.404a-1(a), (b)(i) and (b)(ii)
3. 29 C.F.R Section 2550.404a-1(a), (b)(i) and (b)(ii)
4. Liss v. Smith, 991 F. Supp. 278, 291 (S.D.N.Y. 1998) (Liss)
5. Fink v. National Savs.& Trust Co., 772 F.2d 951, 957 (D.C. Cir. 1985) 
6. Liss, 299
7. Gregg v. Transportation Workers of America Int’l, 343 F.3d 833, 841-42. (Gregg)
8. Jonathan Clements, “Why Big Issuers Are Staying Away From This Year’s Hottest Investment Products,” Wall Street Journal, December 14, 2005, D1 (Clements)
9. Clements
10. Uniform Prudent Investor Act, https://www.uniformlaws.org/viewdocument/final-act-108?CommunityKey=58f87d0a-3617-4635-a2af-9a4d02d119c9 (UPIA)
11. UPIA
12. UPIA
13. UPIA
14. UPIA
15. 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).

Copyright InvestSense, LLC 2023. 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.

Posted in 401k, 401k compliance, 401k investments, 401k litigation, 401k plan design, 401k plans, 401k risk management, 403b, 404c, 404c compliance, Annuities, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, investment advisers, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, RIA, RIA Compliance, risk management, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , | Leave a comment

3Q 2023 AMVR “Cheat Sheets”: Fiduciary Law Benchmarks That Really Matter

Posted on October 2, 2023 by jwatkins

The six funds shown are six of the leading non-index funds that are consistently offered in U.S. domestic defined contribution plans. My development of the Active Management Value Ratio (AMVR) metric was originally based on the work of Nobel laureate Dr. William F. Sharpe and investment expert Charles D. Ellis.

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.1

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns.2

The current version of the AMVR, AMVR 3.0, was modified to incorporate the work of Professor Ross Miller. Miller’s Active Expense Ratio (AER) factors in the high correlation of returns often found between actively managed funds and comparable passively managed/index funds. The AER provides investors with the implicit expense ratio they are paying for an actively managed fund. The AER also helps expose actively managed funds that are arguably “closet index” funds. As Miller explained,

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.3

The 3Q 2023 5 and 10-year AMVR “cheat sheet” numbers provide an opportunity to discuss pending 401(k) litigation that may significantly impact the 401(k) management and fiduciary liability in general. The 5-year “cheat sheet” shows that two funds qualified for an AMVR score.

In order for an actively managed fund to be eligible for an AMVR score, it must first produce a positive incremental return relative to the passively managed benchmark. American Fund’s Washington Mutual Fund received a 5-year AMVR score of 2.94, while Vanguard’s PRIMECAP fund received a 5-year AMVR score of 2.88.

However, neither fund would qualify as being prudent under the Restatement (Third) of Trusts’ fiduciary prudence standards since their AMVR score is greater than 1.00. An AMVR greater than 1.0 indicates that the fund’s incremental costs exceed the fund’s incremental returns. InvestSense uses correlation-adjusted costs and risk-adjusted returns in calculating a fund’s AMVR score, as they provide a more accurate representation of a fund’s cost/benefit to an investor.

The 10-year “cheat sheet” shows that three funds qualified for an AMVR score. American Fund’s Washington Mutual Fund received an AMVR score of 10.36, Vanguard’s PRIMECAP fund received an AMVR score of 1.01, and Fidelity Contrafund K shares received an AMVR score of 1.78.
However, none of the funds would qualify as being prudent under the Restatement (Third) of Trusts’ fiduciary prudence standards since their AMVR score is greater than 1.00, although a strong argument can be made for Vanguard PRIMECAP.

One often overlooked benefit of a fund’s AMVR score is that it provides an easy way to determine a fund’s cost premium. In the case of the 10-year Contrafund K shares analysis, the active fund’s incremental cost was 280 basis points (2.80), while the fund’s incremental return was 157 basis points (1.57).

The financial services typically uses basis points in making comparisons. A basis point is equal to 1/100th of one percent. Contrafund’s AMVR indicates that the fund’s cost premium of 123 basis points was equal to a 78 percent cost premium (AMVR of 1.78 minus 1.00, multiplied by 100).

So how does this all tie into the pending 401(k) litigation cases? The Tenth Circuit Court of Appeals recently issued its much anticipated decision in Matney v. Briggs Gold of North America4. As I summarized in my earlier post, the Tenth Circuit upheld the district court’s dismissal of the plan participants’ 401(k) action claiming that the plan sponsor breached its fiduciary duties by (1) including imprudent investment options within the plan, and (2) imposing unnecessarily high fees on the participants. The Tenth Circuit basically relied on the usual “lack of meaningful benchmarks” and an interpretation of revenue sharing that had previously been rejected by other federal circuit courts of appeal.

The good news is that now the plan participants will, hopefully, apply to SCOTUS for certiorari so that the Court can establish uniform rules on both (1) the propriety of index funds as comparators in 401(k) and 403(b) litigation, and (2) the party who has the burden of proof on the causation of loss issue in such litigation. The Solicitor General submitted an amicus brief in the Brotherston case citing the common law of trusts as placing such burden of proof on a plan sponsor once the plan participants established a fiduciary breach and a resulting loss. The Department of Labor (DOL) recently submitted an amicus brief in the current Home Depot5 401(k) litigation, essentially adopting the Solicitor General’s position.

Various courts have relied on the “lack of meaningful benchmarks” theory in dismissing 401(k) litigation cases. The Tenth Circuit discussed several theories of determining whether a proposed benchmark was actually comparable to the investment option chosen by a plan, including the familiar active/passive argument. The Court also discussed the comparison of expense ratios method, including an interesting argument based on the idea that any revenue sharing generated by funds in a plan must be applied on a 1:1 basis to reduce those funds’ expense ratio on a 1:1 basis. I addressed these issues in my last post.

What I want to discuss in this post is the concept of “meaningful benchmarks,” aka comparators, in connection with the AMVR. The Tenth Circuit suggested that to be a meaningful comparator, plan participants must go beyond performance and factor in questionable collateral issues such as a fund’s management strategies and goals. My position is, and always will be, that such collateral issues are meaningless to plan participants and in 401(k) and 403(b) litigation. A slide I often use in my presentations expresses both my position and what investors consistently tell me.

The investment industry has always argued against using risk-adjusted returns in comparing investment options, stating that you “cannot eat risk-adjusted returns.” The same argument can be made against any requirement that a fund’s strategies and goals must be factored into any fiduciary prudence assessment in connection with ERISA-related litigation. If we recognize the stated purpose of ERISA is to protect employees, then attention in any 401(k) or 403(b) litigation should be solely on a fund’s cost-efficiency, more specifically the benefit that a fund provides to a plan participant relative to the costs/fees incurred.

In the Tibble decision6, SCOTUS recognized the value of the Restatement of Trusts (Restatement) in resolving fiduciary questions. SCOTUS recognized that the Restatement essentially restates the common law of trusts, a standard often used by the courts. The two dominant themes running throughout the Restatement are the dual fiduciary duties of cost-consciousness and diversification within investment portfolios to reduce investment risk.

In my fiduciary risk management consulting practice, I rely heavily on five core principles from the Restatement to reduce fiduciary risk. Three of the five principles are cost-consciousness/cost-efficiency principles:

Comment h(2)’s commensurate standard is a principle that I feel very few fiduciaries do, or can, meet if they include actively managed mutual funds in their plan. Actively managed funds start from behind in comparison to comparable passive/index funds due to the extra and higher expenses they incur from management fees and trading fees. As a result, a case can be made that ERISA plaintiff attorneys could effectively use the Restatement’s commensurate return and SCOTUS’ approval of the Restatement effectively in 401(k) litigation

Advocates of active management often claim that active management provides an opportunity to overcome such cost issues. However, the evidence overwhelmingly indicates that very few do so, with most actively managed funds being able to even cover their extra costs.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.7 

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

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.9

Another factor to consider in such poor performance numbers has to do with the fact that actively managed funds typically show a high correlation of returns to comaparable index funds, with many showing a r-squared number of 90 and above. Such a high correlation of returns could suggest that the active fund involved is actually a “closet index” fund, misleading investors by charging a significantly higher fee than a comparable index fund based on the alleged benefits of the fund’s active management, while actually deliberately tracking, or mirroring, a comparable market index or index fund. Such misrepresentations are arguably fraud and violations of various federal securities laws.

The Restatement and the common law of trusts seemingly resolve both the issues involved in the Matney cases in favor of beneficiaries such as the plan participants. While we wait to see if the plan participants file to seek certiorari from SCOTUS, I have previously suggested that both plan sponsors and ERISA plaintiff attorneys need to act proactively and change the paradigm to use cost-benfit analysis, more specifically the Active Management Value Ratio metric, to analyze the fiduciary prudence of a plan’s investment options.

The AMVR “cheat sheets” consistently document the potential liability issues that plan sponsors have created for themselves. While many plan sponsors have indicated to me that they prefer to just ignore the situation and deal with it if and when a legal action is filed, I try to explain to them that the law does not recognize “willful ignorance” as a defense.

Businesses around the world utilize cost/benefit analysis in their decision making process. I believe that plan sponsors should as well. The familiar adage that a picture is worth a thousand words should hold true in 401(k) litigation, as it is hard to believe that any court would not understand that any investment whose incremental costs exceed its incremental benefits is not, and never will be, prudent under fiduciary law, regardless of the fund’s stated strategies and goals.

When I meet a prospective client, I always show them three AMVR slides representing actual investments in their plans. In most cases, they look at the slides and realize the liability issues they face. In the sample AMVR slide shown, the estimated damages in connection with the fund would be estimated at between $2.06 and $6.57 a share, compounded annually. Then repeat the analysis for every investment option within the plan.That explains why settlements are usually reported in terms of millions of dollars.

One of my mantras to my fiduciary clients is “commensurate returns and common sense” are a strong combination in fiduciary prudence cases. Restatement Section 90, comment h(2) discusses commensurate return in terms of the extra costs and risk plan participants may be asked to incur in a plan’s investment options. That explains why InvestSense uses risk-adjusted returns and correlation-adjusted costs in calculating AMVR scores and fiduciary prudence. Common sense should indicate that cost-inefficient investments are never prudent.

If SCOTUS does hear the Matney case and rule that plan sponsors bear the burden of proving that they did not cause any losses suffered by plan participants, this might well be the type of evidence that plan sponsors will have to counter in order to win the case. In most cases, I do not believe that plan sponsors will be able to overcome the power of “humble arithmetic” and the simplicity, as well as the persuasiveness, of the AMVR evidence.

Going Forward
I believe that SCOTUS will use either the Matney case or the Home Depot case to resolve the inequitable division of the federal courts on the issue of which party in 401(k) litigation has the burden of proof on the issue of causation of loss. I also believe the Court will cite the Restatement to establish that mutual funds cannot be summarily be rejected as legally viable comparators in ERISA litigation, at least for the purposes of prematurely dismissing meritorious cases.

Citing the Sacerdote10 decision, the DOL made an interesting comment in its recent amicus brief in the Home Depot 401(k) action:

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.11

I believe that once SCOTUS rules in the Matney and/or Home Depot cases, courts, attorneys, and plan sponsors will soon recognize the AMVR as a valuable fiduciary risk management analytical tool that can establish both the requisite fiduciary breach and resulting loss, effectively establishing that “no prudent fiduciary” would have chosen a cost-inefficient actively managed mutual fund.

Notes
1. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
2. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
3. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49.
4. Matney v, Barrick Gold of North America, No. 22-4045, September 6, 2023 (10th Circuit Court of Appeals (Matney 10th Circuit).
5. Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022)
6. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
7. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
8. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017.
9. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
10. Sacerdote v. New York University, 9 F.4th 95 (2d Cir. 2021).
11. Department of Labor amicus brief in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022) (Amicus Brief), 26. https://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf

Copyright InvestSense, LLC 2023. 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.

Posted in 401k, 401k compliance, 401k litigation, 401k plan design, 401k plans, 401k risk management, 403b, Active Management Value Ratio, AMVR, closet index funds, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, risk management, SCOTUS, Supreme Court | Tagged , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Making ERISA Meaningful: Common Sense, “Humble Arithmetic,” SCOTUS, and the Matney Case

Posted on September 27, 2023 by jwatkins

The Tenth Circuit Court of Appeals finally issued its much-anticipated decision in Matney v. Briggs Gold of North America1 (Matney). As expected, the Court upheld the district court’s dismissal of the case. The good news is that the Tenth Circuit’s publication of the decision allows the plan participants to apply for certiorari so that SCOTUS can hear an appeal of the Tenth Circuit’s decision

I believe that SCOTUS will grant certiorari and hear the casel if the participants apply for cert given the importance of ERISA in people’s lives and the fact that a split currently exists within the federal court on several critical aspects of ERISA. I also believe that the Court will grant cert in Matney in order to resolve two important questions that were first presented to the Court in the Brotherston case.2

The Court denied certiorari in Brotherston based upon the advice of the Solicitor General of the United States due the fact that the case was still ongoing at that time. While the Solicitor General recommended that SCOTUS not grant certiorari, the Solicitor General stated that the First Circuit Court of Appeals had correctly decided both questions involved and then took the time to provide an excellent analysis of the issues.3

I maintain that Matney is essentially a revisiting of the Brotherston case, as the two key issues in Matney and Brotherston are identical. For that reason, I am going to address the Tenth Circuit’s decision more in terms of the Solicitor General’s excellent amicus brief in Brotherston rather than the Tenth’ Circuit’s opinion, as I believe it will provide a better perspective on SCOTUS’ ultimate decision in the case.

SCOTUS and the Tibble decision
The Tibble decision4 is often cited as setting forth the framework that SCOTUS and other courts use in deciding  ERISA cases.

An ERISA fiduciary must discharge his responsibility “with the care, skill, prudence, and diligence” that a prudent person “acting in a like capacity and familiar with such matters” would use. We have often noted that an ERISA fiduciary’s duty is “derived from the common law of trusts.” In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts. We are aware of no reason why the Ninth Circuit should not do so here.5

Substitute “Tenth Circuit” for “Ninth Circuit,” and I believe you could have the opening paragraph in a SCOTUS’ Matney decision.

As I mentioned earlier, both Matney and Brotherston involve the same two questions:

1. Are comparable market indices and index funds acceptable comparators when the prudence of actively managed mutual funds is an issue in 401(k)/403(b) litigation?

2. Which party bears the burden of proof on the issue of causation of loss in 401(k)/403(b) litigation?

Comparable Index Funds as Comparators 
The Solicitor General opined that the First Circuit Court of Appeals had correctly ruled in Brotherston that index funds are not, as a matter of law, improper comparators for determining whether an ERISA fiduciary breached their fiduciary duties and calculating the resulting damages.6

The Solicitor General noted that determining losses in an ERISA action follows the same procedure as in other fiduciary breach actions, comparing ‘the actual performance of the plan investments and the performance that otherwise would have taken place.” Citing Section 100, comment b(1) of the Restatement, the Solicitor General stated that appropriate comparators may include

[R]eturn rates of one or more suitable common trust funds, or suitable index mutual funds or market indexes (with such adjustments as may be (sic) appropriate.7

The Solicitor General noted that the Brotherston court cited other legal support for the use of index funds as valid comparators in calculating losses due a fiduciary breach.

Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes return rates of one or more … suitable index mutual funds or market indexes (with such adjustments as may be appropriate).8

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.’9

The Solicitor General noted that while the Restatement does not support the absolute rejection of comparable index funds as comparators for assessing fiduciary prudence and the establishing the requisite financial losses, the question as to the appropriateness of the funds chosen remained a question of fact for determination at trial.10

One aspect of establishing fiduciary imprudence and resulting losses in connection with actively managed mutual funds that courts and plan sponsors frequently overlook is the Restatement’s “commensurate return” position. The Restatement states that the use of actively managed funds and active management strategies is imprudent unless the fiduciary can objective predict that the investment in question can be expected to provide a commensurate return for the extra costs and risks assumed by beneficiaries/plan participants.

Studies have consistently shown that the overwhelming majority of actively managed funds fail to provide investors with a commensurate return, as most actively managed funds are cost-inefficient, failing to even cover their costs.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.11 

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.12

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.13

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.14

The cost-inefficiency of most actively managed funds is even more pronounced if the correlation of returns between many actively managed and comparable passively managed funds is factored in. Ross Miller created a metric, the Active Expense Ratio, which measures the impact of correlation of returns in such situations. Miller’s research determined that once correlation of returns is considered, the effective costs investors pay is often 400-500 percent higher than the active fund’s stated expense ratio.15 This would obviously make it that much more difficult for plan sponsors to satisfy the Restatement’s “commensurate return” standard.

John Langbein, the reporter for the committee that drafted the Restatement (Second) of Trusts, had warned in 1976 that

When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.16

Burden of Proof as to Causation of Loss  
As to the burden of proof on causation, the Solicitor General stated that

The ‘default rule’ in ordinary civil litigation when a statute is silent is that ‘plaintiffs bear the burden or persuasion regarding the essential aspects of their claims. But ‘the ordinary default rule, of course, admits of exceptions’17

The Solicitor General noted that one such exception applies under the law of trusts due to the high standards of conduct required of fiduciaries under the law. Citing both the Restatement and a highly respected treatise on trust law, the Solicitor General stated that

Under trust law, “when a beneficiary has succeeded in proving that the trustee has committed a breach of trust and that a related loss has occurred, the burden shift to the trustee to prove that the loss would have  occurred in the absence of the breach.’18

In further support of its position, the Solicitor General noted that the burden shifting on the issue of causation furthers the stated purposes of ERISA.

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.19

The Solicitor General noted that SCOTUS has recognized that in some cases, shifting the burden on the issue of causation to plan sponsors furthers the goals and purposes of ERISA by allowing the plan sponsors to establish “facts peculiarly within the knowledge of” one party.20

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.21

The Department of Labor’s recent amicus brief in the current Hom Depot 401(k) litigation arguably resolved the burden of proof on causation debate by citing the Sacerdote decision in suggesting that

If a plaintiff succeeds in showing that ‘no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, abnd there is no burden left to ‘shift’ to the fiduciary defendant.22

Winds of Further Change
Assuming that Matney applies for certiorari, I believe that SCOTUS will, and should, grant certiorari. The current division within the federal courts on the two questions involved in Matney have essentially made a mockery of ERISA and the fundamental protections guaranteed by the statute. ERISA’s guarantees and protections are far too important to employees to be handled so cavalierly.

One of the primary areas of contention has to do with procedural matters, specifically the relative requirements of the parties in connection with a motion to dismiss. Defendants in civil litigation typically file motions to dismiss in order to reduce costs and avoid the transparency of discovery.

The Second Circuit Court of Appeals Sacerdote v. New York University case23 involved a number of the same issues involved in Matney, including revenue sharing. The court also provided an excellent analysis of the fiduciary standard and the resulting procedural issue in 401(k) litigation in general.

[The fiduciary prudence] standard focuses on a fiduciary’s conduct in arriving at an investment decision, not on its results, and asks whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment.24

A claim for breach of the duty of prudence will “survive a motion to dismiss if the court, based on circumstantial factual allegations, may reasonably infer from what is alleged that the process was flawed” or “that an adequate investigation would have revealed to a reasonable fiduciary that the investment at issue was improvident.”25

Plaintiffs allege that this information was included in fund prospectuses and would have been available to inquiring fiduciaries when the fiduciaries decided to offer the funds in the Plans. In sum, plaintiffs have alleged “that a superior alternative investment was readily apparent such that an adequate investigation” —simply reviewing the prospectus of the fund under consideration—”would have uncovered that alternative.” On review of a motion to dismiss, we must draw reasonable inferences from the complaint in plaintiffs’ favor.26

While the plausibility standard requires that facts be pled “permit[ting] the court to infer more than the mere possibility of misconduct,” we do not require an ERISA plaintiff “to rule out every possible lawful explanation for the conduct he challenges.” To do so “would invert the principle that the complaint is construed most favorably to the nonmoving party” on a motion to dismiss.27

Although plaintiffs bear the burden of proving a loss, the burden under ERISA shifts to the defendants to disprove any portion of potential damages by showing that the loss was not caused by the breach of fiduciary duty. This approach is aligned with the Supreme Court’s instruction to “look to the law of trusts” for guidance in ERISA cases. Trust law acknowledges the need in certain instances to shift the burden to the trustee, who commonly possesses superior access to information.28

When I compare some of the recent dismissals of 401(k)/403(b) actions in the context of the clear standards set out in comments b(1) and f of Section 100 of the Restatement, my initial reaction is to recall Simon Sinek’s outstanding book, “Start With Why.”29

The referenced Restatement sections appear to be necessary, objective and fair. In too many cases, the rash of dismissals appear to be deliberately and unnecessarily draconian and arguably designed to deny plan participants their ERISA’s protections by preventing transparency. some courts have noticed this trend.

The Sixth Circuit Court of Appeals is not necessarily known as an advocate for plan participants. And yet, Chief Judge Sutton addressed the inequitability of the noticeable dismissal trend in certain federal circuits, especially those requiring plan participants to plead and prove the mental processes of plan sponsors and plan investment committees without allowing plan participants to have the discovery needed to discover what processes were used in selecting and monitoring the plan’s investment options.

In rejecting the plan’s arguments on the prudence of selecting actively managed funds for a fund based on the purported benefits of revenue sharing they provided, Judge Sutton adopted a common sense, fundamental fairness argument.

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….’30

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.31

Revenue Sharing
Revenue sharing is a much discussed issue in current 401(k)/403(b) litigation…and with good reason. In my opinion, Matney is a perfect example of the issues involved with revenue sharing and a perfect example of why SCOTUS needs establish a uniform standard on the issue of which party bears the burden of proof on the issue of causation.

Both the district court and the Tenth Circuit relied heavily on their accusation that the plan participants misrepresented the expenses ratios of investment options within the plan that provided revenue sharing. Both courts seemed to argue that the plan participants were obligated to reduce such funds’ expense ratios on a one-to-one basis by the stated revenue sharing amounts.

The attempt by both Matney courts to use revenue sharing to reduce a fund’s expense ratio is totally inconsistent with the Seventh Circuit’s acknowledgment that such attempts to offset expense ratios with revenue sharing payments on a one-to-one basis are improper. In another example of the “fundamental fairness” trend, the Seventh Circuit rejected the district court’s one-to-one offset argument, pointing out that

The problem is that the Form 5500 on which Albert relies does not require plans to disclose precisely where money from revenue sharing goes. Some revenue sharing proceeds go to the recordkeeper in the form of profits, and some go back to the investor, but there is not necessarily a one-to-one correlation such that revenue sharing always redounds to investors’ benefit. Albert’s ‘net investment expense to retirement plans theory’ assumes that there is such a correlation; if that assumption is wrong, then simply subtracting revenue sharing from the investment-management expense ratio does not equal the net fee that plan participants actually pay for investment management.32

I have argued that in cases where revenue sharing is distributed among various cost contributors, far too often the resulting situation is one in which the plan participants are effectively victimized twice, once in simply reducing excessive bookkeeping costs that remain so even after credited with a portion of revenue sharing, then again in leaving plan participants burdened with over-priced, consistently underperforming, i.e., cost-inefficient, actively managed mutual funds. Such a situation is the anti-thesis of fiduciary prudence and the stated purpose of ERISA.

The Second Circuit addressed the fiduciary issues involved with revenue sharing in the Sacerdote case, insight that is equally applicable to the revenue sharing issues in Matney.

The fact that one document purports to memorialize a discussion about whether or not to offer retail shares does not establish the prudence of that discussion or its results as a matter of law.33

We have no quarrel with the general concept of using retail shares to fund revenue sharing. But, there was no trial finding that the use here of all 63 retail shares to achieve that goal was not imprudent. Simply concluding that revenue sharing is appropriate does not speak to how the revenue sharing is implemented in a particular case. We do not know, for example, whether revenue sharing could prudently be achieved with fewer retail shares.34

The Tenth Circuit’s presumptions and premature decisions with regard to the case’s revenue sharing issues may ultimately prove to be the Matney decision’s fatal flaw.

Going Forward
When the Tenth Circuit’s Matney decision was first announced, I received numerous email assuming that I would be upset since, allegedly, my previous Matney-related posts had been proven wrong.

The Matney decision should not have surprised anyone familiar with the Tenth Circuit’s precedent in this area. I just wanted an actual decision so that the plaintiff could begin the certiorari process. As for being wrongI have been wrong before and probably will be again. Then again, I have not heard the fat lady sing yet. If SCOTUS holds true to Tibble and its other ERISA fiduciary prudence decisions, she may never do so.

In the original Matney decision35, the district court recognized that the selection process, not the ultimate performance of the product chosen by a plan, is the key issue in 401(k)/403(b) litigation. Two statements in the Tenth Circuit’s decision particular drew my attention:

(1) “circumstantial factual allegations ‘must give rise to a ‘reasonable inference’ that the defendant committed the alleged misconduct, thus ‘permit[ting] the court to infer more than the mere possibility of misconduct,”36 and

(2) “[t]o show that ‘a prudent fiduciary in like circumstances’ would have selected a different fund based on the cost or performance of the selected fund, a plaintiff must provide a sound basis for comparison—a meaningful benchmark.”37 (emphasis added)

Change “cost or performance” to “cost and performance” and I believe the letter and spirit of ERISA can be easily, and uniformly, accomplished. People who follow my posts are well aware of my position that the relative cost-efficiency of a fund, not its classification as active or passive, not a fund’s stated goals/strategies, should be the key factor in determining whether a plan sponsor or any other investment fiduciary has breached their fiduciary duties.

In the Hughes reconsideration decision38, the Seventh Circuit noted that “cost-consciousness management is fundamental to prudence in the investment function. My Active Management Value Ratio (AMVR) metric provides a simple method of assessing the cost-efficiency of a fiduciary’s decisions. A sample of an AMVR analysis slide is shown below.

The slide clearly establishes a “reasonable inference” of a fiduciary breach, clearly showing the cost-inefficiency of the actively managed mutual fund relative to a comparable index fund, based on the actively managed fund’s incremental cost and return. The combination of the active fund’s relative underperformance (opportunity cost) and the fund’s incremental expense ratio cost could then be used to estimate both the loss and damages caused by the plan sponsor’s fiduciary breach.

The AMVR itself is essentially the basic cost/benefit equation, using incremental cost/return as the input data. The AMVR calculation itself is obtained by dividing an active fund’s incremental cost by its incremental return. An AMVR greater than “1.0” indicates that the actively managed fund is cost-efficient.

Plan sponsors, attorneys and courts can then see the extent of the cost-inefficiency, the “imprudence premium,” being reflected in the amount by which a fund’s AMVR score exceeds “1.0,” e.g., 1.50 indicates an imprudent premium of 50 basis points/50 percent. Estimated liability exposure and/or potential legal damages can then be calculated using the DOJ’s and GAO’s findings that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a 20-year period.39

In the example shown, the fund’s negative incremental return automatically makes the fund an imprudent choice relative to the comparable index fund. While some may want to argue differences in strategies and goals, ERISA and the AMVR ignore the meaningless collateral arguments and focus on the ultimate benefit, if any, provided to the plan participants.

The example demonstrates that whatever the active fund’s strategies and goals may have been, they ultimately proved to be imprudent relative to the performance of the comparable benchmark, failing to provide an investor with a commensurate return for the additional costs and risks. Using the slide, the combined investment costs would have resulted in a loss of between $2.06 to $7.00 per share, compounded annually. Combining the AMVR slide and the findings of the DOL and GAO also shows that an investment in the active fund would have resulted in a plan participant suffering a minimum projected 34 percent loss in end-return over a 20-period relative to the index fund option.

Final Thoughts
If SCOTUS holds true to the position it announced in Tibble, the Restatement arguably provides a simple answer to the two questions posed in the Matney case.

1. Are comparable market indices and index funds acceptable comparators when the prudence of actively managed mutual funds is an issue in 401(k)/403(b) litigation?
 Answer: Section 100, cmt b(1) of the Restatement recognizes the validity of market indices and index funds as comparators in ERISA litigation. The Solicitor General and the First Circuit’s Brotherston do so as well.

2. Which party bears the burden of proof on the issue of causation of loss in 401(k)/403(b) litigation?
Answer: Section 100, comment f, of the Restatement provides as follows:

[W]hen a beneficiary has succeeded in proving that the trustee has committed a breach of duty and that a related loss has occurred, we believe that the burden of persuasion ought to shift to the trustee to prove, as a matter of defense, that he loss would have occurred in the absence of a breach.40

As the Solicitor General, the Department of Labor, and the First Circuit’s Brotherston decision have all pointed out, this position is consistent with the common law of trusts.

At first glance, this would not appear to be a difficult decision for SCOTUS if they remain consistent with their previous decision in Tibble. Since the two key questions are not directly addressed by ERISA, the court would turn to the Restatement.

As noted herein, the Restatement does clearly address and answer both questions. Furthermore, several circuits have addressed both questions and the exact scenarios involved in Matney and have provided practical, fair, and well-reasoned decisions that are consistent with both ERISA, the Restatement, and the common law of trusts.

The ongoing division within the federal courts on ERISA issues, and the unwillingness of some courts to adopt the Restatement’s clear and equitable standards, reminds me of a quote by the late General Norman Schwarzkopf that I frequently used in my closing argument to a jury

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

Hopefully, SCOTUS will be provided with the opportunity to do so by simply combining the Restatement with a little common sense and “humble arithmetic.”

Notes
1. Matney v, Barrick Gold of North America, No. 22-4045, September 6, 2023 (10th Circuit Court of Appeals (Matney 10th Circuit).
2. Solicitor General’s Brotherston amicus brief , 6-7. (Amicus brief)
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018). (Brotherston)
4. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
5. Amicus brief, 19.
6. Amicus brief, 20.
7. Amicus brief, 20.
8. Amicus brief, 20.
9. Amicus brief, 39.
10. Amicus brief, 19.
11. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
12. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017.
13. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
14.. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
15. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49.
16. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007. http://digitalcommons.law.yale.edu/fss_papers/498
17. Amicus brief, 8.
18. Amicus brief, 8. (citing the Restatement (Third) of Trusts, Section 100, comment f (2012)
19. Amicus brief, 10-11.
20. Amicus brief, 11.
21. Brotherston, 39.
22. DOL’s Amicus brief in Pizarro v. Home Depot, 26.
23. Sacerdote v. New York Universit, 9 F.4th 95 (2d Cir. 2021). (Sacerdote)
24. Sacerdote, 107.
25. Sacerdote, 108.
26. Sacerdote, 108.
27. Sacerdote, 108.
28. Sacerdote, 113.
29. Simon Sinek, “Start With Why,” (Portfolio:London 2009).
30. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022). (TriHealth)
31. TriHealth, 453.
32. Albert v. Oshkosh Corp., 47 F.4th 570, 581 (7th Cir. 2022).
33. Sacerdote, 111.
34. Sacerdote, 111.
35. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022).
36. Amicus Brief, 8.
37. Amicus brief, 21.
38. Hughes v. Northwestern University, No. 18-2569 (7th Cir. 2022), 14 (“So “cost-conscious management is fundamental to prudence in the investment function,…” (citing RESTATEMENT (THIRD) OF TRUSTS § 90, cmt. B; see also id. § 88, cmt. A (“Implicit in a trustee’s fiduciary duties is a duty to be cost- No. 18-2569 15 conscious.”). “Wasting beneficiaries’ money is imprudent.” UNIF. PRUDENT INVESTOR ACT § 7, cmt. (UNIF. L. COMM’N 1995).
39. 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).
40. Restatement of the Law Third, Trusts copyright © 2007 by The American Law Institute. Reproduced with permission. All rights reserved.

Posted in 401k, 401k compliance, 401k investments, 401k litigation, 401k plan design, 401k plans, 401k risk management, 403b, Active Management Value Ratio, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, risk management, SCOTUS, Supreme Court | Tagged , , , , , , , , , , , , , , , | Leave a comment

Why Smart Fiduciaries Avoid Annuities: “Humble Arithmetic,” Annuities, and Fiduciary Liability

Posted on September 3, 2023 by jwatkins

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

[A] victim to the relentless rules of humble Arithmetic. Remember, O stranger, ‘Arithmetic is the first of the sciences and the mother of safety.’
U.S. Supreme Court Justice Louis Brandeis

Fiduciary law is essentially a combination of trust, agency, and equity law. A fiduciary is always required to put their beneficiaries’ interests first, to always act in their beneficiaries’ best interests. As Justice Benjamin Cardozo wrote in Meinhard v. Salmon:

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 then the standard of behavior.1

When a plaintiff’s attorney is involved in a case with catastrophic injuries, such as a wrongful death case, the defendant often suggests that the parties agree to a “structured settlement,” a settlement which usually involve some up-front money, but one in which the majority of damages are to be paid by periodic payments provided by an annuity.

People often ask me why I am so opposed to annuities. Part of my opposition to annuities is a result of my experiences with annuity wholesalers during my days as a compliance director. However, my opposition is due primarily from my experience as a plaintiff’s attorney.

When the defendant and their counsel propose a stated settlement amount, too many attorneys do not understand how to properly evaluate the value of the settlement/annuity. As a result, many plaintiff’s attorneys have faced malpractice actions for unintentionally misrepresenting the value of the settlement to their clients.

Today, many courts have addressed the fundamental fairness problem by requiring the defendant to provide the plaintiff and the court with the actual price that the defendant will have to pay for the annuity to be used in the settlement, the court taking the position that said price is the present value of the proposed settlement. Even now, some defendants refuse to disclose the actual price of the proposed annuity. In such cases, the plaintiff’s attorney can ask the court to approve a “qualified settlement fund,” into which the actual settlement funds will be temporarily deposited and then prudently invested.

The current attempt by the annuity industry to make inroads into 401(k) and 403(b) plans reminds me of the marketing ploys utilized by the annuity industry in connection with structured settlements. The annuity industry was telling the courts and anyone else who would listen that structured settlements and annuities were necessary because over 90 percent of personal-injury victims were dissipating the proceeds of their settlements within five years.

A NYU law student conducted a thorough research project and found that there was no empirical evidence to support such a claim.2 The insurance and annuity industry admitted that there was no evidence to support the claim and instructed its members to stop using the claim.

Which brings us to the current campaign by annuity advocates to increase the use of annuities within 401(k) and 403(b) plans, the advocates arguing that plan participants desire “guaranteed income for life. But do plan sponsors and plan participants understand how such annuities work and the associated costs involved. As the late fee-only insurance adviser Peter Katt used to caution, “but at what cost?”

A CEO recently contacted me and asked me why I refer to annuities as “fiduciary traps.” I showed him the analysis shown below, a structured settlement analysis that I had once prepared for a case. He looked up and told he now understood why I referred to annuities as “fiduciary traps.” He asked me why these issues were never explained to plan sponsors in this way. My response was simple – “Would you include annuities in your plan provided with such information?”

The analysis below uses methodologies included in Paul Lesti’s excellent treatise on analysis of structured settlements.3 Lesti cautioned that

Many annuities are not for a specified number of years. Most annuities are payable for the life of the annuitant, possibly with some period certain.4

Lesti notes that analyzing annuities in terms of their present value, factoring in the time value of money, is one commonly used method used in analyzing annuities. However, Lesti cautions that an analysis based on present value alone may be misleading:

The more accurate method is to calculate the present value of each probable payment.5

In the case of a nonguaranteed annuity, it is necessary to calculate the probability that the person will be alive to receive each payment. Multiply the probability by the amount to be received, and then multiply this amount by the applicable discount factor.6

The chart below uses the suggested methodology, with a slight variation in the order of presentation to make the concept and impact of present value calculations a little easier to understand. The “twist” does not alter the end results.

As I tell my fiduciary risk management clients, always insist that the annuity salesperson provide you with a similar chart, showing the actual calculations and the breakeven point, the point at which the annuity owner could be said to receive a commensurate return on the original investment. Unless the plan participant/annuity owner will receive a commensurate return for the extra risks and costs associated with an annuity, a valid argument can be made under the common law of trusts that the investment results in a fiduciary breach due to the windfall issue. A basic tenet of equity law is that “equity abhors a windfall.”

The chart reflects an analysis of the purchase of a $250,000 annuity, paying a flat 4 percent a year, by a 65-year-old male. The last two columns of the chart show the results of a present value analysis of the annuity in question, one based on present value alone, the other based on present value with probability of receipt of payment factored in. The probability numbers are calculated from annual mortality tables. Note: The mortality numbers/factors shown are from a 2014 case and do not reflect the current mortality factor numbers.

The numbers in the last two columns break down the numbers at the 10, 20, and 30 year marks, with a final analysis if the annuitant were to reach age 100. Given the prospective annuity owner’s current life expectancy at age 65, approximately 17 years, the numbers speak for themselves. Explains why annuity issuers pay such high commissions for annuity sales. I would also submit that the numbers clearly establish the strength of a potential fiduciary breach claim against a plan sponsor for both prudence and loyalty, due to the lack of a commensurate return, resulting in a significant windfall in favor of the annuity issuer at the plan participant’s expense.

Annuity advocates often counter that annuity owners do care about present value calculations as long as they receive “guaranteed income for life.” Based on my personal experience, once annuity owners are provided with the relevant information and realize the true situation, they care deeply.

Annuity owners often realize that they cannot make ends meet with the income produced by an annuity alone. When I explain that they can sell their annuity, but that the price they will receive will be a deeply discounted number based on the annuity’s present value, they do care.

Going Forward
When I hear people talking about purchasing an annuity, whether it be a qualified annuity, an annuity purchased within a pension plan, or a non-qualified annuity, an annuity purchased outside a pension plan, I just wish I could perform a forensic analysis for them using Lesti’s methodology so they would have “sufficient information to make an informed decision,” the same standard required of plan sponsors seeking the safe harbor protection of ERISA Section 404(c). Plan sponsors considering offering annuity options within their plan must determine how, and if, they are going to provide such valuable information to each plan participant in order to meet the “sufficient information” requirement of section 404(c), or simply forego the potential protection offered by the section.

In my 42 years of practicing law, I have rarely seen an analysis of a life annuity that factors in both present value and the mortality/probability of receiving payments issues. The chart shown explains why prospective annuity customers are not provided with such an analysis.

The chart also supports one commentator’s suggestion that such present value calculations and charts “suggest that those providing annuities understand present value calculations, while those who are forced to purchase their products do not.”7 This lack of transparency allows the annuity industry to continue to recommend inequitable annuities and potentially expose plan sponsors and other investment fiduciaries to unnecessary fiduciary liability.

Both SECURE and SECURE 2.0 were intended to provide potential safe harbors for plan sponsors that choose to include annuities within their plans. Plan sponsors should note that those potential safe harbors apply to liability under ERISA. It appears that plan participants would still be able to sue plan sponsors under such common law causes of action such as negligence and fraud for inclusion of annuties, in any form, within a plan

Chris Tobe has discussed a number of the inherent issues connected with annuities, such as single entity credit risk, illiquidity, and excessives costs, on our “The CommonSense 401(k) Project) web site, Given the evidence provided by the chart herein and other such inherent issues with annuities, one can only wonder why plan sponsors would unnecessarily expose themselves to potential fiduciary liability by even considering including annuities in their plans. I guess it proves the truth of the saying, “common sense ain’t so common.”

ERISA does not require that plans offer any specific type of investment, including annuities. ERISA only requires that each investment option within a plan be legally prudent. So, again, why would plan sponsors even consider including annuities within their plan? Annuity advocates and plan sponsors argue that plan participants want choice, guaranteed income, and peace of mind in retirement. My response is that plan participants who still want to purchase annuities after being presented with all the relevant facts could still do sooutside the plan, without exposiing the plan and plan sponsors to an risk of fiduciary liability.

Just as I have consistently argued that cost-inefficient actively managed mutual funds do not constitute a legitimate “choice,” forensic analyses of annuities factoring in both present value and mortality issues clearly establish the legal imprudence of annuities. Proof of this can be provided by simply insisting that the annuity salesperson provide you with a forensic analysis chart that factors in both present value and mortality/probability of payment issues.

Both the legal and annuity industries are still awaiting decisions in both the Matney8 and Home Depot9 401(k) litigation cases. The key issue in both cases is who has the burden of proof on the issue of causation of harm. A number of federal courts, the Solicitor General of the United States, and the Department of Labor have already opined that once the plan participants establish a fiduciary breach and a resulting loss, the plan sponsor has the burden of proving that their actions did not cause such losses. As these parties have pointed out, this is the only equitable result since only the plan sponsor knows why they made the decisions that resulted in a berach of their fiduciary duties.

I am on record as saying that I believe that the Matney and Home Depot decisions will ultimately result in increased 401(k) and 403(b) litigation, both between plans/plan participants and plans/plans advisers. I believe that the combination of the Active Management Value Ratio metric and forensic analyses of annuities using Lesti’s methodology will help plan participants carry their burden of proof, while making it very difficult for plan sponsors to carry their burden of proof.

The next 12 to 18 months promise to be very interesting, and telling, for 401(k) and 403(b) plan sponsors.

Notes
1. Meinhard v. Salmon, 249 N.Y. 458, 464 (1928).
2. Jeremy Babener, “Justifying the Structured Settlement Tax Subsidy: The Use of Lump Sum Settlement Monies,” NYU Journal of Law & Business (Fall 2009)
3. Paul J. Lesti, “Structured Settlements,” (Bancroft-Whitney Co.: 1986). (Lesti)
4. Lesti, 114.
5. Lesti, 114.
6. Lesti, 114.
7. Guy Fraser-Sampson, “No Fear Finance: An Introduction to Finance and Investment for the Non-Finance Professional,” (Kogan Page: 2011)
8. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022).
9. Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022), 24.

Copyright InvestSense, LLC 2023. 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.

Posted in 401k, 401k compliance, 401k investments, 401k litigation, 401k plan design, 401k plans, 401k risk management, 403b, Active Management Value Ratio, AMVR, Annuities, compliance, consumer protection, cost consciousness, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement planning, retirement plans, risk management, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Could the Matney and Home Depot Decisions Signal the End of the 401(k)/403(b) Litigation SNAFU? Are Plan Sponsors Really Ready?

Posted on August 21, 2023 by jwatkins

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

People often ask me why I write and comment so much about the Matney case.1 As a fiduciary risk management counsel, my job is to monitor developments in fiduciary law and help my fiduciary clients avoid unnecessary liability risk exposure.

Three issues have continued to trouble fiduciary law: the “menu of options” defense, the issue of whether index funds are meaningful comparators in assessing fiduciary prudence, and the issue of who has the burden of proof as to loss causation regarding plan participant losses. The Hughes2 decision finally resolved the “menu of options” issue. Section 100 of the Restatement (Third) of Trusts should resolve the “meaningful comparators” issue.

The Matney case, as well as the Home Depot case, involve a common question, namely which party in a 401(k)/403(b) litigation action has the burden of proof on the issue of loss causation. The problem is that there is currently a split of opinion on the question in the federal courts, effectively denying some plan participants the rights and protections guaranteed to them under ERISA.

Legal Background – Brotherston
The issue of who carries the burden of proof on the issue of causation was a key issue in the First Circuit Court of Appeal’s Brotherston decision.3 The First Circuit relied heavily on the common law of trusts in ruling that the burden of proof on causation necessarily belonged to the plan sponsor. The Court noted that fiduciary prudence vis-à-vis causation is process oriented, determined by looking at the prudence of the process employed by a plan sponsor in selecting investment options for a plan, rather than at the ultimate performance of the investment option itself.

The Court noted that since the process used by the plan sponsor is typically known only to the plan sponsor, and since many courts do not plan participants the opportunity for discovery to learn what processes, if any, were used by the plan sponsors, placing the burden of proof of causation on the plan sponsor is both inequitable and inconsistent with the standards established by the common law of trusts. Numerous courts have since adopted the First Circuit’s position.

In an interesting development, the Sixth Circuit recently noted the inequity of requiring plan participants to prove that the plan’s fiduciary process was flawed without the benefit of being allowed to discover exactly what the plan sponsor’s process was, stating that

[D]iscovery holds the promise of sharpening this process-based inquiry…. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case…. 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.4

Legal Background – Sacerdote
Another key case on the issue on who has the burden of proof on the issue of causation is the Sacerdote v. New York University (NYU) case.5 Some of the facts in this case border on the unbelievable and the absurd, including some members of the investment committee testifying that they did not even know that they were on the investment committee and others testifying that they did not know what they were doing and why they were on the investment committee. Nevertheless, the district court ruled in favor of NYU.

On appeal, the Second Circuit of Appeals reversed several of the district court’s key ruling, including the court’s ruling on the fiduciary prudence of the investment options chosen by the plan. The Court started out by stating the applicable standard for consideration of a motion to dismiss in 401(k) litigation:

[The fiduciary prudence] standard focuses on a fiduciary’s conduct in arriving at an investment decision, not on its results, and asks whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment.6

A claim for breach of the duty of prudence will “survive a motion to dismiss if the court, based on circumstantial factual allegations, may reasonably infer from what is alleged that the process was flawed” or “that an adequate investigation would have revealed to a reasonable fiduciary that the investment at issue was improvident.”7

The Court then addressed the case itself:

Plaintiffs allege that this information was included in fund prospectuses and would have been available to inquiring fiduciaries when the fiduciaries decided to offer the funds in the Plans. In sum, plaintiffs have alleged “that a superior alternative investment was readily apparent such that an adequate investigation” —simply reviewing the prospectus of the fund under consideration—”would have uncovered that alternative.” On review of a motion to dismiss, we must draw reasonable inferences from the complaint in plaintiffs’ favor.8

While the plausibility standard requires that facts be pled “permit[ting] the court to infer more than the mere possibility of misconduct,” we do not require an ERISA plaintiff “to rule out every possible lawful explanation for the conduct he challenges.” To do so “would invert the principle that the complaint is construed most favorably to the nonmoving party” on a motion to dismiss.9

Second, we caution against overreliance on cost ranges from other ERISA cases as benchmarks. While such comparisons may sometimes be instructive, their utility is limited because the assessment of any particular complaint is a “context-specific task.” We cannot rule out the possibility that a fiduciary has acted imprudently by including a particular fund even if, for example, the fees that fund charged are lower than a fee found not imprudent in another case.10

When the university attempted to present some notes as evidence that the investment committee did employ a prudent process in reviewing and selecting the plan’s investment option, the Court cautioned that simply employing some semblance of a “process” does not automatically ensure compliance with ERISA.

The fact that one document purports to memorialize a discussion about whether or not to offer retail shares does not establish the prudence of that discussion or its results as a matter of law.11

We have no quarrel with the general concept of using retail shares to fund revenue sharing. But, there was no trial finding that the use here of all 63 retail shares to achieve that goal was not imprudent. Simply concluding that revenue sharing is appropriate does not speak to how the revenue sharing is implemented in a particular case. We do not know, for example, whether revenue sharing could prudently be achieved with fewer retail shares.12

The Court then addressed a key problem in far too many dismissals of 401(k)/403(b), courts confusing “losses” with “damages,” and the party bearing the burden of proof as to each.

Moreover, we are hard-pressed to rely on the discussion of loss that the district court did undertake because the discussion was somewhat unclear in several respects. It conflated loss with damages, appeared to answer a question the court claimed to leave undecided, and effectively misallocated the burden of proof on damages.13

To be clear, these terms are not interchangeable. Loss is measured in this context by “a comparison of what the [p]lan actually earned on the investment with what the [p]lan would have earned had the funds been available for other [p]lan purposes. If the latter amount is greater than the former, the loss is the difference between the two.” The question of how much money should be awarded to the plaintiffs in damages is distinct from, and subsequent to, whether they have shown a loss. The district court’s conflation of the two concepts saps our confidence in its analysis on this subject.14

Although plaintiffs bear the burden of proving a loss, the burden under ERISA shifts to the defendants to disprove any portion of potential damages by showing that the loss was not caused by the breach of fiduciary duty. This approach is aligned with the Supreme Court’s instruction to “look to the law of trusts” for guidance in ERISA cases. Trust law acknowledges the need in certain instances to shift the burden to the trustee, who commonly possesses superior access to information.15

The Court then cited the First Circuit’s observation in Brotherston that “[i]t makes much more sense for the fiduciary to say what it claims it would have done and for the plaintiff to then respond to that.”16

The DOL’s Amicus Brief
The Department of Labor (DOL) recently filed a welcome amicus brief in the Home Depot 401(k) action addressing the issue of the party carrying the burden of proof regarding loss causation in 401(k)(403(b) litigation.

Under the correct burden-shifting framework, where Home Depot (the movant) bears the burden to disprove loss causation, Home Depot could have prevailed at summary judgment on that element only if it presented evidence allowing a reasonable fact finder to conclude that the alleged breach did not cause the Plan’s losses. In short, Home Depot would have to prove “that a prudent fiduciary would have made the same decision.”17

The DOL then provided the potential “shot heard around the ERISA world,” a statement that will no doubt re repeated in future 401(k)/403(b) litigation, especially motions to dismiss:

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.18 (citing Sacerdote)

Common Law, ERISA, and the Restatement of Trusts
In the Tibble decision19, SCOTUS recognized the Restatement of Trusts (Restatement) as a valuable resource in resolving questions involving questions regarding a fiduciary’s legal duties. SCOTUS also noted that both the Restatement and ERISA are largely based on the common law of trusts.

Two dominant themes that run throughout ERISA are cost-consciousness and importance of diversification to minimize the risk of large losses. Regarding cost-consciousness, the Restatement, sets out three important considerations:

1. Section 88, comment b, of the Restatement states that fiduciaries have a duty to be cost-conscious.

2. Section 90, aka the “Prudent Investor Rule,” comment f, states that a fiduciary has a duty to seek the highest rate of return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of expected return.

3. Section 90, comment h(2), goes even further regarding a fiduciary’s duty to be cost-efficient, stating that due to the extra costs and risks typically associated with actively managed mutual funds, such funds should not be recommended to and/or used unless their use/recommendation can be “justified by realistically evaluated return calculations” and can be “reasonably expected to compensate” for their additional costs and risks.

Studies have consistently shown that the overwhelming majority of actively managed funds are not cost-efficient.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.20  

Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.21

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.22

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.23

The Active Management Value Ratio (AMVR)
Several years ago I created a metric, The Active Management Value Ratio (AMVR), which allows investors, investment fiduciaries, and attorneys to quickly evaluate the cost-efficiency of an actively managed fund. The AMVR is based on the research and concepts of noted investment experts such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, Burton G. Malkiel. The latest iteration of the AMVR includes the valuable research of Ross Miller, whose Active Expense Ratio metric factors in the correlation of returns between an actively managed fund and a comparable index fund to provide a more accurate evaluation of cost-efficiency.24

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

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

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

The Fiduciary Prudence ScoreTM is a proprietary trademark of InvrestSense, LLC. The proprietary trademark for the actively managed fund shown in the referenced AMVR slide would be negative seven (-7.00)

The AMVR only requires the ability to do simple arithmetic calculations using performance and costs data that is freely available on several web sites such as morningstar.com, yahoo.com, and marketwatch.com. For more information on the AMVR, click here.

Going Forward
While the Brotherston and Sacerdote are valuable decisions in deciding the issue as to the party required to carry the burden of proof regarding loss causation in 401(k)/403(b) litigation, The DOL’s amicus brief provides the quick and easy answer for resolving the pending Matney and Home Depot cases.

As I always remind my fiduciary clients, prudent plan sponsors do not select cost-inefficient investment options for their plan.

By using the AMVR to evaluate the fiduciary prudence of potential plan investment options and the potential resulting loss, 401(k)/403(b) plan sponsors can minimize the risk of unnecessary fiduciary liability exposure and improve the plan participants’ odds of “retirement readiness. At the same time, ERISA plaintiff attorneys can use the AMVR to evaluate the fiduciary prudence of potential plan investment options and calculate any losses due to non-compliance with ERISA.

The DOL’s amicus brief, together with the Brotherston and Sacerdote decisions, have provided SCOTUS with the necessary evidence as to why the burden of proof as to loss causation, by necessity, must either be shifted to the plan sponsor or plan participants must be allowed to have “controlled,” or limited, discovery to determine the prudence of the process the plan used in investigating and evaluating the investment options chosen by the plan. Now the courts have the opportunity to do so.

Notes
1. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022). (Matney)
2. Hughes v. Northwestern University, 142 S.Ct. 737 (2022).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018). (Brotherston)
4. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022).
5. Sacerdote v. New York University, 9 F.4th 95 (2021) (Sacerdote).
6. Sacerdote, 107.
7. Sacerdote, 108.
8. Sacerdote, 108.
9. Sacerdote, 108.
10. Sacerdote, 108-109.
11. Sacerdote, 109.
12. Sacerdote, 111.
13. Sacerdote, 112.
14. Sacerdote, 112.
15. Sacerdote, 113.
16. Sacerdote, 113.
17. Department of Labor amicus brief in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022), 24. (Amicus Brief). http://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
18. Amicus Brief, 26
19. Tibble v. Edison International, 135 S. Ct 1823 (2015)
20. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
21. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e.&nbsp.
22. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
23.. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
24. 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.
25. Amicus Brief, 26.

Copyright InvestSense, LLC 2023. 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.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k plans, 401k risk management, 403b, Active Management Value Ratio, AMVR, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investment advisers, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, risk management, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , | Leave a comment

3 Key Questions for Plan Sponsors on Annuities, “Guaranteed Income,” and Fiduciary Liability Under ERISA – 2025

Posted on July 17, 2023 by jwatkins

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

Seems that social media and trade publications are focused on the issue of “guaranteed lifetime income” options within ERISA plans, with various studies indicating that plan participants would be interested in a source of guaranteed income during retirement. That response should not come as a surprise to anyone.

Would the results be different if the question was framed differently by adding material information. Framing refers to presenting situations in such a way as to influence an individual’s response by appealing to the individual’s cognitive biases. A primary example is to present a scenario where one response will result in gain, while the other response will result in a loss.

So, presenting a poll or the results of a study which indicates that retirees would be interested in a source of guaranteed lifetime income during retirement, or at any time for that matter, is hardly earth shattering. However, what would be the likely results if we frame the same question slightly differently to disclose additional requirements and/or disadvantages, such as the following:

Would you be interested in a product that can guarantee you income for life? The only requirement would be that to receive the lifetime stream of income, you will have to surrender both control of the product and the accumulated value within the product to the company offering the product, with no guarantee of receiving a commensurate return in exchange for such concessions, as well as agreeing that the company offering the product or other third parties, not your heirs, will receive any residual value in your account when you die.

I have never had one person respond positively to my version of the “guaranteed lifetime income”/annuity sales pit.ch During my compliance days, my brokers became very familiar with my mantra – “all God’s children do not need an annuity.” A well-known saying within the annuity industry is that “annuities are sold, not bought.” Plan sponsors should remember that saying and the reasoning behind it.

Annuity advocates will often point out that annuities often offer so-called “riders” that do guarantee a return of the annuity owner’s principal to the annuity owner’s heirs…for an additional price. With annual fees within an annuity often running two percent or more, the additional fee for “riders” serves to further reduce an annuity owner’s end-return.

As both the Department of Labor and the federal General Accountability Office have pointed out, each additional one percent in fees and expenses in a product reduces an investor’s end-return by approximately 17 percent over a twenty-year period.1 Riders often cost an additional one percent or more of the annuity’s accumulated value. When combined with an annuity’s other annual costs, it is easy to see how over half of an annuity owner’s end-return can be lost in an annuity’s annual fees (3 times 17).

Annuities, Plan Sponsors, and the Fiduciary Liability Gauntlet
A CEO invited me to lunch recently to discuss the potential liability issues of offering annuities within his company’s 401(k) plan. Before lunch was over, two other executives sitting nearby came by our table and asked me to call them to discuss the issue.

Full disclosure – I do not like annuities. Never have, never will. My strong dislike of annuities is due primarily to my experience with the annuity industry during my time as a plaintiff’s attorney . I was involved in litigating some medical malpractice and wrongful death cases. When a personal injury case potentially involves significant monetary damages, the defendant’s insurer typically suggests a structured settlement involving an annuity.

As a plaintiff’s attorney, if the defense offers to settle for a million dollars, the plaintiff’s attorney has to ensure that the plaintiff is actually going to receive a settlement with a present value of a million dollars. Failure to do so will typically result in a malpractice claim against the attorney.

The courts have consistently held that the present value of a settlement involving an annuity is the actual purchase price of the annuity, the out-of-pocket costs the insurance company will incur in purchasing the annuity being considered. However, many insurance companies refuse to disclose the actual purchase price of the annuity since it is typically well below the agreed upon settlement price, ensuring a windfall for the annuity issuer. Fortunately, the plaintiff can avoid such dishonesty by asking the court to approve of the creation of a “qualified settlement fund, ” (QSF) into which the settlement proceeds are paid so that the plaintiff can purchase an annuity at a fair price and avoid full and immediate taxation of the settlement proceeds.

I see a similar situation potentially developing in the annuity industry’s current campaign to offer more annuity products within pension plans. As a fiduciary risk management counsel, my job is to explain the potential fiduciary liability pitfalls to plan sponsors in order to avoid unnecessary liability exposure. In my presentations, I currently focus on four areas: (1) a plan sponsor’s duty to personally investigate and evaluate each investment option within a plan, (2) ERISA Section 404(c)’s “adequate information to make an informed decision” requirement, (3) a plan sponsor’s fiduciary duty, which includes a duty to disclose all material information to plan participants, and (4) a plan sponsor’s fiduciary prudence duties under ERISA Section 404(a).

ERISA Section 404(a)’s “Knew or Should Have Known” Standard
Section 404(a) sets out a plan sponsor’s fiduciary duty of prudence:

a fiduciary shall discharge his duties with respect to a plan …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;…2

In determining whether a trustee has breached his duties, the court examines both the merits of the challenged transaction(s) and the thoroughness of the fiduciary’s investigation into the merits of the transaction(s).3

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard. (citing Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983); Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981). 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/her attention had he/she fully complied with their duty to investigate and evaluate all plan investment options. It is the imprudent investment rather than the failure to investigate and evaluate that is the basis of suit; breach of the latter duty is merely evidence bearing upon breach of the former, tending to show that the trustee should have known more than he knew.# (emphasis added)4

While courts recognize, even encourage, the use of third parties in the fiduciary’s investigation and evaluation process, the courts have consistently warned that plan sponsors and other plan fiduciaries may not blindly rely on such experts, especially “experts” that are commission salespersons.

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”5

“The failure to make an independent investigation and evaluation of a potential plan investment is a breach of fiduciary duty.”6

Sponsors must conduct a thorough and objective investigation and evaluation in selecting investment products for a plan. Fiduciary prudence focuses on the process used by a plan sponsor in investigating and evaluating the investment products chosen for a plan, not the eventual performance of the product. In assessing the process used by a plan sponsor, the court evaluate prudence in terms of both procedural and substantive prudence.

Procedural prudence focuses on whether the fiduciary utilized appropriate methods to investigate and evaluate the merits of a particular investment. Substantive prudence focuses on whether the fiduciary took the information from the investigation and made the same decision that a prudent fiduciary would have made.

The Tatum v. RJR Pension Inv. Committee decision7 provides an excellent analysis of various types of fiduciary prudence – objective prudence, procedural prudence, and subjective prudence. It also involves the analysis of an annuity, although in a defined benefit plan context.

The court first addressed the concept of “objective prudence, stating that

A decision is objectively prudent is a hypothetical prudent fiduciary would have the same decision.8 (emphasis added)

I have deliberately added emphasis to the word “would,” as it was a pivotal issue in the court’s decision. The plan sponsor had argued, and the lower court had accepted their argument, that it was sufficient to show that a hypothetical prudent fiduciary “could” have made the same decision.

The Fourth Circuit Court of Appeals rejected that argument, stating that the chosen word with regard to the applicable fiduciary prudence standard was more than just a matter of semantics.

ERISA requires fiduciaries to employ “appropriate methods to investigate the merits of the investment and to structure the investment” as well as to “engage in a reasoned decision-making process, consistent with that of a `prudent man acting in [a] like capacity.'”9

In other words, although the duty of procedural prudence requires more than “a pure heart and an empty head,” courts have readily determined that fiduciaries who act reasonably — i.e., who appropriately investigate the merits of an investment decision prior to acting — easily clear this bar.10

[I]n matters of causation, when a beneficiary has succeeded in proving that the trustee has committed a breach of trust and that a related loss has occurred, the burden shifts to the trustee to prove that the loss would have occurred in the absence of the breach.” (citing Restatement (Third) of Trusts § 100, cmt. f (2012))11

As the Supreme Court has explained, the distinction between “would” and “could” is both real and legally significant….[C]ould” describes what is merely possible, while “would” describes what is probable.12

The “would have” standard is, of course, more difficult for a defendant-fiduciary to satisfy. And that is the intended result. “Courts do not take kindly to arguments by fiduciaries who have breached their obligations that, if they had not done this, everything would have been the same.” …We would diminish ERISA’s enforcement provision to an empty shell if we permitted a breaching fiduciary to escape liability by showing nothing more than the mere possibility that a prudent fiduciary “could have” made the same decision.13 (cites omitted

The court then went on to address the issue of objective and substantive prudence:

a decision is “objectively prudent” if “a hypothetical prudent fiduciary would have made the same decision anyway.”14 (emphasis added)

As mentioned earlier, substantive prudence focuses on the plan sponsor’s consideration of the facts uncovered in its investigations and whether the plan sponsor properly factored in such information and made a legally proper decision.

Other courts have identified key factors that plan sponsors must address in considering annuities.

A fiduciary must consider any potential conflict of interest, such as a potential reversion of plan assets, and structure its investigation accordingly.15

Just as with experts’ advice, blind reliance on credit or other ratings is inconsistent with fiduciary standards.16 

With regard to the potential reversion of plan assets involving annuities or the receipt of same by third parties, such as other annuity owners of the insurance comapny, I would (and have) argued that the fact that reversion to the annuity issuer is especially egregious and constitutes a breach of a plan sponsor’s fiduciary duties of both loyalty and prudence based upon the fact that such a reversion would constitute a windfall for the annuity issuer or a related party, the annuity issuer’s other annuity owners, at the annuity owner’s expense. Equity law is a component of fiduciary law, and “equity abhors a windfall.”

The court concluded by emphasizing that the controlling criteria was whether an annuity under consideration was in the best interest of the plan participants and their beneficiaries. The question will be whether plan sponsors can obtain the necessary information to independently evaluate and verify the accuracy of such information, as well as the ability to interpret the implications of the annuity information they can uncover.

For example, will plan sponsors be able to determine whether plan participants will even be able to breakeven on a particular annuity, especially if the annuity issuer retains the right to reset the terms? Will plan sponsors be able to understand the difference between an ordinary annuity and an annuity due and provide plan participants with the information on the financial implications of each, e.g., breakeven analysis?

ERISA’s “Adequate Information to Make an Informed Decision” Requirement
Plan sponsors typically try to qualify as a 404(c) plan in order to receive immunity from liability for the ultimate performance of the plan participants’ investment choices. Qualification for such protection requires compliance with approximately twenty requirements. As a result, many plan sponsors mistakenly believe they are in compliance with 404(c) when they actually are not.

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

(i) Provides an opportunity for a participant or beneficiary to exercise control over assets in his individual account (see paragraph (b)(2) of this section); and

(ii) Provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his account are invested (see paragraph (b)(3) of this section).

(2) Opportunity to exercise control.

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

(B) The participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed investment decisions with regard to investment alternatives available under the plan, and incidents of ownership appurtenant to such investments. For purposes of this paragraph, a participant or beneficiary will be considered to have sufficient information if the participant or beneficiary is provided by an identified plan fiduciary (or a person or persons designated by the plan fiduciary to act on his behalf)…17

As pointed out earlier, the financial services industry, in particular the insurance/annuity industry, are not known for their support of transparency and/or full disclosure. Transparency and full disclosure are the financial services kryptonite. Anytime there is any mention of a true fiduciary standard for the industry, the industry’s lobbyists grab their checkbooks and head toward Capitol Hill, as the financial services industry knows that few, if any, of its products would comply with a true fiduciary standard. They just hope that plan sponsors and consumers never realize that fact.

Annuities present a number of challenges for plan sponsors hoping to qualify for 404(c) protections. Annuities are extremely complex, and deliberately so. There is a saying within the annuity industry, “annuities are sold, not bought.” Anyone who truly understands guaranteed lifetime income annuities would never consider buying one, especially when viable, cost-efficient alternatives are readily available that do not require the investment owner to agree to the unnecessarily harsh terms required by annuity companies.

Annuities have been described as a bond wrapped in an expensive insurance wrapper. The primary issue with commercial annuities is the associated costs, both in terms of monetary costs and opportunity costs in terms of other financial goals, such as estate planning. Annuity advocates will often turn to their “guaranteed income for life” and “no loss” mantras. Annuity opponents will counter with their “at what cost” mantra and the viable cost-efficient alternatives available. Financial service publications have run articles explaining how financial advisers can even help their customers create viable, cost-efficient annuity substitutes.

With annual fees/spreads often in the range of two percent or more, plan sponsors should remember the findings of both the Department of Labor and the General Accountability Office that each additional one percent in fees reduces an investor’s end-return by approximately seventeen percent over a twenty-year period.18 Add a rider charging an additional annual fee of one percent and the investor now faces a reduction of over half of their end-return (3 times 17). Hard to see how a plan sponsor can explain the prudence of including annuities reducing end-returns by one-third to one-half, or more, over more cost-efficient, investor friendly alternatives.

There is no requirement that a 401(k) plan qualify as a 404(c) plan. However, the inability to qualify as a 404(c) plan potentially raises a number of fiduciary prudence and loyalty questions. Given the annuity industry’s unwillingness to provide material information about their products, how can a plan sponsor perform the legally required independent and objective investigation and evaluation required by ERISA? Likewise, how will a plan sponsor provide the ongoing monitoring of each annuity and annuity related product offered within a plan?

If a plan offers annuities which allow the annuity provider to reset or otherwise change the terms of the annuity to protect and benefit the annuity issuer, what are the options and potential consequences for both plan participants and plan sponsors? An even more basic question for plan sponsons is how do they determine whether sufficient information has been, and will continue to be, provided. Remember, plan sponsors that chose to blindly rely on third party information face an unforgiving legal system. These are just some samples of legal liability issues that plan sponsors should consider before choosing to include annuity options within a 403(k) or 403(b) plan. Unfortunately, annuity advisers generally try to avoid addressing such potential legal liability issues. “Not our job” and “we are not acting as fiduciaries” is their common response.

Annuities and ERISA Requirements
ERISA does not expressly require plan sponsors to offer annuities, in any form, within a 401(k) or 403(b) plan. It’s just that simple.

In fact, ERISA does not expressly require a plan to offer any specific type of investment product. ERISA 404(a) only requires that each investment option within a plan be prudent. SCOTUS resolved that issue in the Hughes v. Northwestern University19 case.

So, the obvious question is why, given the various hurdles and the potential fiduciary liability traps inherent with annuities, would a plan sponsor voluntarily expose themselves to unnecessary fiduciary liability exposure? After all, a plan participant wanting to purchase an annuity could easily do so outside of the plan, without creating any potential liability issues for the plan sponsor.

Plan sponsors often try to justify the inclusion of an otherwise legally imprudent investment option based upon a desire to provide plan participants with “choices.” A legally imprudent investment option never has been, and never will be, a legally valid investment “choice.” The fact that a plan sponsor would even include a legally imprudent investment, e.g., a cost-inefficient actively managed mutual fund, simply serves as a red flag for regulators with regard to the overall prudence of the plan’s selection process.

The good news is that it is relatively simple to design and maintain an cost-effective and ERISA compliant 401(k) or 403(b) plan. The bad news is that far too few plan sponsors do so.

Going Forward

[A] fiduciary satisfies ERISA’s obligations if, based upon what it learns in its investigation, it selects an annuity provider it “reasonably concludes best to promote the interests of [the plan’s] participants and beneficiaries.”20

Based on the information presented herein and a plan sponsor’s fiduciary duties of prudence and loyalty, key questions in future 401(k)/403(b) litigation involving the inclusion of annuities and/or annuity related products in plans could/should include

(1) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan when that annuity requires the annuity owner to surrender both the investment contract and the accumulated value within the annuity without any guarantee of a commensurate return?

(2) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan when the terms of the annuity contract legitimately raises questions as to the odds of the annuity owner ever breaking even and, if so, how long it would take?

(3) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan if the annuity issuer reserves the right to reset the terms and guarantees within the annuity and impact the results of questions (1) and (2).

(4) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan if the fees were so excessive as to potentially reduce an annuity owner’s end-return by one-third or more?

(5) Under the SECURE Act, plans sponsors are protected from liability in the event that annuities offered within their plan are unable to honor their financial commitments under their contracts. Yet, plan participants who purchase such annuities within a plan are not protected against loss in such circumstances. Given the obvious inequity in the event of such a situation, where plan sponsors are protected but plan participants are not, would the courts consider your decision to offer such annuities in your plan to be a breach of your fiduciary duties of prudence and/or loyalty?

If, as many ERISA attorneys expect, SCOTUS rules that the burden of proof as to causation shifts to the plan sponsor once the plan participants prove a fiduciary breach and resulting loss, these are questions that plan sponsors are going to be forced to face in future 401(k)/403(b) litigation. The answers, and resulting liability, would appear to be readily apparent.

While most people would agree that the concept of “guaranteed lifetime income” is highly desirable, from a legal and fiduciary liability perspective, the concept always needs to be balanced and conditioned on the question of “at what cost?” As mentioned earlier, in this case, “costs” that would need to be considered are not only financial costs, but also opportunity costs, such as the impact on estate planning and other types of financial planning.

Many would argue that the various costs and concessions associated with annuities, in any form, are simply not worth the “costs,” especially when other equally effective and more cost-efficient alternatives and strategies are available, such as dividends and bonds, e.g., Treasury and corporate, and laddering such bonds. Corporate trust departments often rely on the dividends on utility stocks for guaranteed income. Trusts departments and some fiduciaries have been known to create their own annuities using a combination of bonds, life insurance, and index mutual funds.

I am on record as predicting that the defined contribution arena is going to undergo a significant change in the next 12-18 months, especially in the area of litigation, as a result of the pending decisions in the Cunningham v. Cornell University and the Retirement Security Rule cases. A key question in both cases is which party carries the burden of proof on the issue of causation in defined contribution litigation.

I believe that both cases will result in the burden of proof on the issue of causation in 401(k) /403(b) litigation being shifted to the plans since they alone have access to all of the relevant information. As a result, I believe that there will be a significant increase in the number of cases litigated, both between plans/plan participants and plans/plan advisers, due largely to the fact that most plans cannot and will not be able to successfully meet the burden of proving that their investment selections did not play a role in causing losses sustained by plan participants.

As I explain to my fiduciary risk management clients, there are some well-recognized fiduciary standards that should be followed in evaluating and selecting investments offering guaranteed income. Exposing a plan to unnecessary fiduciary liability exposure is one of those standards, with my corollary for fiduciaries is simply “annuities – Not legally required, so why go there? Don’t go there.”

Previous posts on the unnecessary liability exposure that annuities create for defined contribution plans can be found here, here, and here

Notes
1. 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”).
2. 29 C.F.R. § 2550.404(a)-1; 29 U.S.C. § 1104(a).
3. The failure to make any independent investigation and evaluation of a potential plan investment is a breach of fiduciary obligations. Fink v. National Savs. & Trust Co., 772 F.2d 951, 957 (D.C. Cir. 1985) (Fink), In re Enron Corp. Securities, Derivative “ERISA“, 284 F.Supp.2d 511, 549-550, Donovan v. Cunningham, 716 F.2d at 1467.52
4. Fink, 962. (Scalia dissent)
5. Liss v. Smith, 991 F. Supp. 278, 299.
6. United States v. Mason Tenders Dist. Council of Greater NY,, 909 F. Supp 882, 887 (S.D.N.Y. 1995)
7. Tatum v. RJR Pension Inv. Committee, 761 F.3d 346 (4th Cir. 2014). (Tatum).
8. Tatum, 363.
9. Tatum, 358.
10. Tatum, 363.
11. Bussian v. RJR Nabisco, Inc., 223 F.2d 286, 300 (5th Cir. 2000). (Bussian)
12. Tatum, 365.
13. Tatum, 365.
14. Tatum, 363; Bussian, 300 (5th Cir. 2000).
15. Bussian, 300.
16. Bussian, 301.
17. 29 C.F.R. § 2550.404(c); 29 U.S.C. § 1104(c).
18. 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).
19. Hughes v. Northwestern University, 142 S. Ct. 737, 211 L. Ed. 2d 558 (2022
20. DOL Interpretitive Bulletin 95-1.

Resources
Collins, P.J., Lam, H., & Stampfi, J. (2009) “Equity indexed annuities: Downside protection, but at what cost?” Journal of Financial Planning, 22, 48-57.

FINRA Investor Insights (2022) “The Complicated Risks and Rewards of Indexed Annuties”  The Complicated Risks and Rewards of Indexed Annuities | FINRA.org

FINRA Investor Alert (2003) “Variable Annuities: Beyond the Hard Sell”

Frank, L., Mitchell, J. & Pfau, W. “Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios,” Journal of Financial Planning, April 2014, 38-47. 

Katt, P. (November 2006) “The Good, Bad, and Ugly of Annuities,” AAII Journal, 34-39.

Lewis, W. Chris. 2005. “A Return-Risk Evaluation of an Indexed Annuity Investment.” Journal of Wealth Management 7, 4.

McCann, C. & Luo, D. (2006). “An Overview of Equity-Indexed Annuities.” Working Paper, Securities Litigation and Consulting Group.

Milevsky, M. & Posner, S. “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.

Olson, J. “Index Annuities: Looking Under the Hood.” Journal of Financial Services Professionals. 65-73 (November 2017),

Reichenstein, W. “Financial analysis of equity-indexed annuities.” Financial Services Review, 18 (2009) 291-311.

Reichenstein, W. (2011), “Can annuities offer competitive returns?” Journal of Financial Planning, 24, 36.

Securities and Exchange Commission. (2008) “Investor Alerts and Bulletins: Indexed Annuties,”SEC.gov | Updated Investor Bulletin: Indexed Annuities

Sharpe, W.F. (1991) “The arithmetic of active management,” Financial Analysts Journal, 47, 7-9.

Terry, A. & Elder, E. (2015) “A further examination of equity-indexed annuities,” 24, 411-428.

Copyright InvestSense, LLC 2023, 2025. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide personal 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.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k plans, 401k risk management, 403b, 404c, 404c compliance, AMVR, Annuities, best interest, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, investments, pension plans, plan sponsors, prudence, retirement plans, risk management, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , | Leave a comment

2Q 2023 “Cheat Sheets”: Plan Sponsors’ IDK/FOFO Strategy and the Future of Fiduciary Liability and Litigation

Posted on July 2, 2023 by jwatkins

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

An analysis of the 2Q “cheat sheets” can be summed up quite simply – “the song remains the same.” None of the six funds qualified for an AMVR score based on either the 5 or 10-year analysis, meaning that the funds proved to be cost-inefficient, and thus legally imprudent, under the standards established by the Restatement (Third) of Trusts (Restatement). Readers are reminded that InvestSense bases its AMVR analysis of actively managed funds on incremental risk-adjusted returns and incremental correlation-adjusted costs, as explained later herein

For new followers, the “cheat sheets” provide a 5 and 10-year cost-efficiency analysis of the non-index funds in the ten most commonly used funds in U.S. defined contribution plans, based on “Pensions & Investments” annual poll. But this trend has even more relevance given the amicus brief that the Department of Labor (DOL) filed in the Home Depot 401(k) case currently pending in the 11th Circuit Court of Appeals. As the DOL pointed out in the amicus brief, the message within the brief was intended for the 10th Circuit as well, as they consider the same question in the Matney case.

First, a few of the pertinent quotes from the amicus brief.

ERISA is silent on who bears the burden of proving loss causation in fiduciary breach cases.1

As the Supreme Court and this Court have recognized, where ERISA is silent, principles of trust law—from which ERISA is derived—should guide the development of federal common law under ERISA. Trust law provides that once a beneficiary establishes a fiduciary breach and a related loss, the burden on causation shifts to the fiduciary to show that the loss was not caused by the breach.2

This burden-shifting framework reflects the trust law principle 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.”3 

Trust law requires breaching fiduciaries to bear the risk of proving loss causation because fiduciaries 14 often possess superior knowledge to plan participants and beneficiaries as to how their plans are run. (citing Restatement (Third) of Trusts § 100 cmt. f)4

In short, [a plan sponsor] has to prove “that a prudent fiduciary would have made the same decision.”5 (emphasis added)

At this point, the DOL made an interesting observation, citing the Second Circuit’s Sacerdote v. New York University decision, in particular the Court’s observation that

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.6

Proving Fiduciary Breach and Loss
The DOL’s amicus brief relied heavily on the common law of trusts. This is appropriate given the fact that the courts have consistently noted that ERISA is essentially the codification of the common law of trusts. The Restatement is just that, a restatement of the common law of trusts, which is why SCOTUS recognized the Restatement as a valid resource in resolving fiduciary disputes.

Two dominant themes throughout ERISA are cost-consciousness/cost-efficiency and diversification. In my role as a fiduciary risk management counsel, I focus on three key Restatement provisions addressing cost-consciousness:

So, with these three principles in mind, how do plaintiffs establish both the plan sponsor’s breach of their fiduciary duties and the resulting loss?

Actively managed mutual funds still dominate most 401(k) and 403(b) plans. A couple of years ago, I created a simple metric, the Active Management Value RatioTM (AMVR). The AMVR allows plans sponsors and other fiduciaries, as well as investors and attorneys, to quickly and easily assess the prudence of an actively managed funds against a comparable index fund.

One of the most common actively managed funds in 401(k) and 403(b) plans is Fidelity’s Contrafund Fund, K shares (FCNKX). A five-year and a ten-year AMVR analysis of FCNKX is shown below.

An actively managed fund’s AMVR score is calculated by dividing the fund’s incremental correlation-adjusted costs by its incremental risk-adjusted return. The costs and return calculations are based on comparisons to a comparable index fund.

The AMVR slides shown above also show how the prudence/imprudence of an actively managed fund can quickly be determined by just answering two questions:

(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?
(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?

If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and imprudent according to the Restatement’s prudence standards and should be avoided. The goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental return), but equal or less than “1” (indicating that the fund’s incremental costs did not exceed the fund’s incremental return).

Assuming that the burden of proof on causation is shifted to the plan sponsor, what is the likelihood that the plan sponsor could successfully carry such burden, could prove “that a prudent fiduciary would have made the same decision?”7

In the five-year analysis, FCNKX failed to even produce a positive incremental risk-adjusted return. Strike One.

If you treat the underperformance (-1.45) as an opportunity cost and combine it with the incremental nominal cost (0.42), the projected loss in end-return over a twenty-year period would be approximately 32 percent. The projected loss would be even greater, approximately 81 percent, if a more realistic cost analysis was conducted using the Active Expense Ratio. Strike Two.

One often overlooked benefit of the AMVR is that it indicates the premium that a cost-inefficient investment extracts from an investor. In this case, the AMVR indicates that an investor would be paying a premium of 331 basis points…while receiving nothing in return. Strike Three.

In the ten-year analysis, FCNKX did provide a slight positive incremental return (0.31). However, the fund was still cost-inefficient, as it did not manage to cover the fund’s incremental costs (0.42), resulting in a net loss for an investor. As the comment to Section Seven of the Uniform Prudent Investors Act states, “wasting beneficiaries, money is imprudent.”8

The 10-year AMVR analysis of FCNKX provides further evidence of why fiduciaries should always calculate a fund’s incremental costs using Miller’s Active Expense Ratio, as it factors in the correlation of returns between two investments to provide a more realistic evaluation of an investment’s value-added benefit, or lack thereof. In this case, the AER calculates that FCNKX is providing approximately 12.50 percent of active management. Factoring in the implicit AER expense ratio (3.36) would result in an investor suffering a projected loss of approximately 56 percent in their end-return over a twenty-year period.

In this case, since the fund did produce a positive risk-adjusted return, we can calculate an AMVR score using the Vanguard Large Cap Growth Index fund as a benchmark. FCNKX’s high r-squared/correlation of return (98) results in an AMVR score of (10.67) (3.31/0.31), indicating that an investor would be paying a premium of over 900 percent ((10.67-1) x 100).

It is hard to see how a plan sponsor, if confronted with such evidence, could carry the burden of proving that their choice of FCNKX as a plan investment was not imprudent. In fact, as pointed out earlier, the Second Circuit Court of Appeals has suggested as much.

The Active Expense Ratio
People frequently ask me why I use the Active Expense Ratio in the AMVR. Their question basically asks why plan sponsors, trustees, RIAs and other fiduciaries never mention the AER if it is so meaingful and important.

The answer is simply that the combination of the AMVR and the AER provide a level of analysis that frequently exposes the imprudence of a recommended investment in comparison to other available alternatives. Transparency is the financial and insurance industries’ kryptonite. Prove it to yourself by asking them to provide you with an AMVR exactly as shown herein.

I had one follower do just that. He reported that the plan adviser came back with a modified version of the AMVR which he claimed were “improvements.” The follower spotted the attempt to conceal the imprudence of the adviser’s recommendations. A framed copy of the follower’s polite note sits proudly on my desk.

Ross Miller, the creator of the Active Expense Ratio metric, summed up the value 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 index.9

By separating the relative costs of passive management and investment management, then calculating the amount of active management contributed by the actively managed fund, a fiduciary can derive the implicit cost of the active management provided by the actively managed fund. The higher an actively managed fund’s r-squared/correlation of returns to a comparable index fund and/or the higher the active fund’s incremental cost relative to the comparable index fund, the higher the actively managed fund’s AMVR score, cost-inefficiency, and legal imprudence. This is just the type of transparency the investment and insurance industries try to avoid, as they consistently oppose any type of true fiduciary standard requiring full and honest disclosure in making investment recommendations.

Going Forward
Being a pack rat has its benefits. In researching my files for this post, I ran across this valuable reminder from a TIAA-CREF publication entitled “Assessing Reasonableness of 403(b) Retirement Plan Fees”:

Plan sponsors are required to look beyond fees and determine whether the plan is receiving value for the fees paid.

Based on my experience, the AMVR suggests that the overwhelming majority of 401(k) and 403(b) plans and plan participants are not receiving value when compared to available investment alternatives, true alternatives under an open architecture platform. Plan sponsors can, and should, perform an objective fiduciary prudence audit using both the AMVR and the AER.

This is especially true since there are currently two cases pending in the federal appellate court that essentially address the

Whether, in an action for fiduciary breach under [ERISA], once the
plaintiff establishes a breach and a related plan loss, the burden
shifts to the fiduciary to prove that the loss is not attributable
to the fiduciary’s breach.10

As the DOL’s amicus brief mentions, the common law of trusts supports the position that the burden of proof on causation properly belongs to the plan sponsor/fiduciary. The majority of the federal Circuit Courts of Appeals agree, as does the Solicitor General of the United States. SCOTUS has already recognized that the Restatement is a respected resource that the courts often look to in resolving fiduciary issues.

Therefore, one can legitimately argue that very soon the courts will be required to shift the burden of proof on causation to plan sponsor once the plan participants establish the breach and resulting loss. The evidence presented herein suggests that that will be a burden many plan sponsors are unable to fulfill.

Enjoy the 4th!

Notes
1. Department of Labor amicus brief in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022) (Amicus Brief), 10. https://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
2. Amicus Brief, 10.
3. Amicus Brief, 13.
4. Amicus Brief, 14.
5. Amicus Brief, 24.
6. Amicus Brief, 26.
7. Amicus Brief, 24.
8. Uniform Prudent Investor Act (UPIA), Section 7 (Introduction).
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. Amicus Brief, 2.

Copyright InvestSense, LLC 2023. 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.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, investment advisers, investments, Mutual funds, pension plans, plan advisers, plan sponsors, prudence, retirement plans, risk management, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , | Leave a comment