“The Lie of the Pie”: Mutual Fund Marketing “Trickeration”

Posted on May 30, 2022 by jwatkins

by James W. Watkins, III

The financial services industry likes to use charts…a lot of charts. Attorneys do not like charts. Charts can be confusing and misleading, sometimes deliberately so. One judge told me that after I had argued the connection between charts and “weaseleze,” in a trial, he always grinned when an attorney tried to introduce a chart.

I tend to use the terms “weasel words” and “weaseleze” a lot. The terms come from Scott Adams’ book, “Dilbert and the Way of the Weasel.” Adams defines weaseleze as

Words that make perfect sense when individually, but when artfully arranged, they become misleading or impenetrable. Weaseleze is often used in advertising, legal work, employee performance reviews, and dating.1

One of the services I provide is fiduciary oversight services. Part of those services includes a forensic fiduciary audit. I tend to see a lot of weaseleze during such audits, often in connection with charts and diagrams. Lee Munson, author of “Rigged Money,” best described the use of weaseleze in connection with charts and diagrams with his phrase “the lie of the pie,”2

During a recent fiduciary audit of a 401(k) plan, the chairman of the investment committee politely questioned my findings, stating that they had followed the recommendations of their plan adviser.

I asked to see the documentation that the plan adviser had provided to the plan. I immediately recognized an ad that the adviser had provided in support of his recommendations. The ad is one used by a major mutual fund company claiming that their funds have beaten S&P 500 Index funds over an extended period of time.

I reminded the investment committee that they have a fiduciary duty to conduct their own objective investigation and evaluation of the funds chosen for their plan. Then I explained why mutual fund companies choose ads comparing their funds to market indices, rather than comparable index funds, knowing that they are arguably misleading.

First, the S&P 500 Index is technically classified as a large cap blend index. Prior to the Hughes v. Northwestern University (Northwestern) decision, the 401(k) industry, the investment industry, and even some courts objected to any comparison between actively managed funds and index funds, claiming that such comparisons were improperly comparing “apples and oranges.”

The Northwestern finally discredited such arguments. However, the use of the S&P 500 Index, or any other market index, to benchmark funds that are inconsistent with a fund’s classification is obviously comparing “apples and oranges.” This often results in misleading comparisons and potential liability exposure for plan sponsors and other investment fiduciaries.

Second, I have seen ads where the mutual fund company’s ads compare their funds to the S&P 500 Index’s returns without including the reinvestment of the Index’s dividends. Historically, over 40 percent of the Index’s returns can be attributed to the reinvestment of its dividends.

Excluding dividends in performance illustrations obviously creates misleading comparisons.

  • Over the ten-year period 2012-2021, the total return of the S&P 500 Index without the reinvestment of dividends was 251.67 percent (13.40 percent annualized) versus 325.33 percent with reinvestment of dividends (15.57 percent annualized).
  • Over the twenty-year period 2002-2021, the total return of the S&P 500 Index without the reinvestment of dividends was 301.13 percent (7.193 percent annualized) versus 488.87 percent with reinvestment of dividends (9.27 percent)

One mutual fund company is known for consistently engaging in this practice. Fortunately, their charts immediately raise red flags for attorneys and fiduciaries to investigate.

Finally, the decision to benchmark against market indices rather than comparable market indices suggests that the fund company is trying to prevent plan sponsors and other investment fiduciaries from performing a cost-efficiency evaluation of their funds.

Section 90 of the Restatement sets out several relevant cost-efficiency standards in determining whether a fiduciary has fulfilled its fiduciary duty of prudence, including

  • A fiduciary has a duty to be cost-conscious.3
  • In selecting investments, a fiduciary has a duty to seek either the highest level of a return for a given level of cost and risk or, inversely, the lowest level of cost and risk for a given level of return.4
  • Due to the impact of costs on returns, fiduciaries must carefully compare funds’ costs, especially between similar products.5
  • Due to the higher costs and risks typically associated with actively managed mutual funds, a fiduciary’s selection of such funds is imprudent unless it can be shown that the fund is cost-efficient.6

The fact that mutual fund companies and plan advisers would attempt to avoid cost-efficiency comparisons is not surprising. Studies have consistently concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient.

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

[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.10

What is troubling from a legal standpoint is that a plan adviser would knowingly try to expose their client, the plan, to unnecessary fiduciary liability exposure. While they typically feign surprise when they are confronted with this evidence, they known exactly what they are doing.

More often than not, their advisory contract with the plan also includes a fiduciary disclaimer clause. Fortunately for plans, the Supreme Court has ruled that such clauses do not prevent plans from suing plan advisers.

The Active Management Value Ratio™3.0
For all the foregoing reasons, I advise my fiduciary compliance clients to simply ignore any and all mutual fund ads and perform their own fiduciary compliance analyses using the Active Management Value Ratio (AMVR).

Based upon the Restatement and the studies of investment icons such as Nobel laureate Dr. William F. Sharpe and Charles D. Ellis, I created a simple metric, the Active Management Value Ratio™ (AMVR), that allows investors, investment fiduciaries and attorneys to quickly determine the cost-efficiency of an actively managed mutual fund.

In analyzing an investment option, Nobel laureate William F. Sharpe has noted that

[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

Building on Sharpe’s theory, investment icon Charles D. Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.

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

The AMVR metric provides extremely useful information regarding the cost-efficiency of an actively managed mutual fund using just a fund’s nominal, or publicly reported, costs and returns. However, an investor’s analysis should not end there if they want a truly accurate cost-efficiency analysis of an actively managed mutual fund.

There is a direct, negative relationship between a fund’s r-squared correlation number, a fund’s incremental costs, and the fund’s cost-efficiency. Morningstar states that “r-squared reflects the percentage of a fund’s movements that are explained by movements in its benchmark index, [rather than any contribution by the fund’s management team.]”13

Professor Ross Miller did a study on the impact of closet indexing, focusing primarily on the relationship between an actively managed mutual fund’s R-squared number, “closet index” status, and the resulting overall financial impact of the two. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but who charge much higher fees than the index fund. The higher an actively managed fund’s r-squared number, the greater the likelihood that the actively managed fund can be classified as a closet index fund.

An r-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to the performance of a comparable index fund rather than the active fund’s management team.

In fairness, Professor Miller has noted that there is not a one-to-one correlation between an actively managed fund’s r-squared number and the percentage of the active management provided.

There is no universally agreed upon level of r-squared that designates an actively managed mutual fund as a closet index fund. I use an R-squared correlation number of 90 as my threshold indicator for closet index status.

Miller’s findings were extremely interesting, namely that

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.11

As a result of his study, Ross Miller, created the Active Expense Ratio (AER) metric. A fund’s AER number is based on a fund’s r-squared number.

Since many investors are unfamiliar with the AER metric, a frequent question I receive is why even calculate an AER-adjusted AMVR. One of the benefits of calculating an actively managed fund’s AER number is that the calculation process results in calculating the actual percentage of active management provided by the actively managed fund in question. Miller refers to this measurement as a fund’s “active weight.14

Deriving a fund’s “active weight” number provides valuable insight into the amount of active management provided by a fund purporting to provide active management, especially since such funds higher fees are based on the purported benefits of active management. However, Miller claims the primary benefit of calculating a fund’s AER number is that the AER provides investors with a quantitative analysis of the implicit cost of the fund’s active management component. The AER accomplishes this by simply dividing an actively managed fund’s incremental cost by the fund’s active weight number.

In many cases, once a fund’s r-squared correlation number is factored in, the fund’s AER is significantly higher than the fund’s stated expense, often as much as 400-500 percent higher. Investors and investment fiduciaries should remember John Bogle’s advice on investment costs, “you get what you don’t pay for,” as well as the fact that simple mathematics proves that each one percent in fees and expenses reduces an investor’s or fiduciary’s end-return by approximately seventeen percent over a twenty-year time period.

Once AMVR is calculated for an actively managed fund, the investor or fiduciary only needs to answer two simple questions:

(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?

(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?

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

Prudent plan sponsors and other investment fiduciaries do not knowingly waste money by offering and/or investing in cost-inefficient investments. It may require a little more work, but by using the AMVR metric, alone or in combination with Miller’s AER metric, investors can better protect their financial security and investment fiduciaries can hopefully avoid unnecessary personal liability exposure.

Going Forward

Facts do not cease to exist because they are ignored.
Aldoux Huxley

As one commentator noted in 1976 after the Restatement (Second) Trusts was released made the following observation:

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.15

Over forty years later, the First Circuit echoed such sentiments in the Brotherston decision, when it offered the following advice:

Moreover, any fiduciary of a plan such as the plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”16

One of the rewarding things about my posts is receiving constructive feedback from readers. A member of a plan investment committee recently wrote me a very nice email, including the following questions and comment:

In your opinion, should our advisor provide [AMVR] calculations as part of their service?

[The AMVR] should be THE comparison that every investor uses to evaluate a fund.

My response as to requiring plan advisors to provide AMVR analyses on their recommendations has, and always be, yes. Why would any plan adviser refuse to provide such simple analyses unless they are not committed to putting a client’s best interests first?

However, insist that they follow the AMVR format used by InvestSense, including risk-adjusted returns and correlation-adjusted costs, using the Active Expense Ratio. In most cases they will provide the calculations based on nominal returns and costs, but they refuse to provide the adjusted data.

As for the AMVR being THE leading metric for complying with one’s fiduciary prudence duty, let’s just say I’m obviously biased. For what it is worth, more fiduciaries and attorneys are reportedly using the metric.

Copyright InvestSense, LLC 2022. All rights reserved.

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

Posted in 401k, 401k compliance, 401k investments, Active Management Value Ratio, AMVR, asset allocation, closet index funds, clsoet index funds, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, evidence based investing, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary standard, investment advisers, investments, Mutual funds, pension plans, plan sponsors, prudence, wealth management, wealth preservation | Tagged , , , , , , , , , , | Leave a comment

Redefining Fiduciary Prudence for 401(k) Plan Sponsors

Posted on May 15, 2022 by jwatkins

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

The legal requirement for prudence, as defined in ERISA Section 404(a)(1)(B), is for a fiduciary to discharge his or her 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.”

But what does that really mean?

[R]ather than explicitly enumerating all of the powers and duties of trustees and other fiduciaries, Congress invoked the common law of trusts to define the general scope of their authority and responsibility.”1

Thus, a federal common law based on the traditional common law of has developed and is applied to define the powers and duties of ERISA plan fiduciaries….2

OK, getting closer.

The two consistent themes throughout the Restatement are cost-consciousness/cost-efficiency and risk management through effective diversification. Section 90 of the Restatement, more commonly known as the Prudent Investor Rule, contains three comments that could, and should, define prudence in future ERISA excessive fees/breach of fiduciary duty actions.

  • A fiduciary has a duty to be cost-conscious. (Introductory Section to Section 90)
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return. (cmt. f)
  • Actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent. (cmt. h(2)).

I collectively refer to these three comments as the “fiduciary prudence trinity.”

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.3

Nobel laureate Dr. William Sharpe has offered the following advice for analyzing the prudence of mutual funds:

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative”4

Noted wealth management expert, Charles D. Ellis, goes further, stating that

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!5

Cumulatively, I submit that these comments and quotes suggest that the best way to prove compliance with one’s fiduciary duties is to quantify such duties. The Active Management Value Ratio™ (AMVR) metric provides a simple way of proving compliance with these fiduciary prudence standards.

The AMVR analysis shows that the actively managed fund produced a positive incremental return of five basis points at an incremental cost of 72 basis points. As we all learned in our basis economics classes, any situation where costs exceed benefits is not a prudent is not a prudent choice.

I am often asked why the AMVR uses adjusted returns. As the Restatement pointed out, an actively managed fund or a strategy that employs active management is only prudent if an investor receives a commensurate return for the additional risks and costs typically associated with active management.

Another questions I often receive is what is the purpose of the “AER” column. AER stands for Active Expense Ratio, the metric created by Ross Miller. The AER factors the correlation of returns between an actively managed fund and a comparable index fund to determine the effective expense ratio of an actively managed fund.

So why calculate an actively managed fund’s correlation-adjusted expense ratio? As Miller explains,

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund 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

While the calculation methodology for the AER can be intimidating, the AER essentially divides an actively managed fund’s incremental costs by its “active weight.” The active weight is a metric created by Miller to determine the true amount of active management provided by an allegedly actively managed fund.

Based upon my experience, formerly as a securities/RIA compliance officer and now as a securities/ERISA attorney and fiduciary compliance consultant, financial advisers and plan advisers rarely discuss or provide AER numbers in connection with their recommendations. That is exactly why InvestSense includes AER data in its forensic fiduciary analyses, to help fiduciaries aware of potential fiduciary liability issues and the need for additional risk management.

In this example, the r-squared, or correlation of returns, number was 98, which translates into an AW of 0.1250, or 12.50 percent of active management within the actively managed fund. The AER is therefore 5.76 (0.72/.1250), resulting in an incremental CAC (correlation-adjusted cost) of 5.59, which makes the actively managed fund’s cost-efficiency even worse.

Going Forward
I believe that the combination of the “fiduciary responsibility trinity,” (Tibble v. Edison International, Brotherston v. Putnam Investments, LLC, and Hughes v. Northwestern University), and the “fiduciary prudence trinity,” will combine to increase the level of fiduciary litigation and eventual settlements, Investment fiduciaries can use the AMVR metric to proactively manage such liability risk exposure by identifying potential liability issues and adopting the necessary changes to bring their plans/accounts into compliance with ERISA and the Restatement.

Notes
1. In re Enron Corp. Securities, Derivatives, and ERISA Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003)
2. Ibid.
3. Liss v. Smith, 991, F. Supp. 278, 297 (S.D.N.Y. 1988)3
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 at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.Sharpe
6. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.

© Copyright 2022 InvestSense, LLC. All rights reserved.

“InvestSense,” the “InvestSense” logo, “Active Management Value Ratio. and the “Active Management Value Ratio” logo ” are trademarks of InvestSense, LLC.

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, 403b, Active Management Value Ratio, AMVR, closet index funds, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, DOL fiduciary rule, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, investment advisers, investments, pension plans, plan sponsors, prudence, retirement plans, risk management | Tagged , , , , , , , , , , , , , , | Leave a comment

At What Cost?: Annuities, Cryptocurrency, and Fiduciary Law

Posted on May 9, 2022 by jwatkins

A [fiduciary] is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is the standard of behavior….1

Fiduciary law is a combination of three types of law–trust, agency and equity. The basic concept of fiduciary law is fundamental fairness.

SCOTUS has consistently recognized the fiduciary principles set out in the Restatement (Third) of Trusts (Restatement) as guidelines for fiduciary responsibility, especially for plan sponsors.

ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.2

Under the Restatement, loyalty and prudence are two of the primary duties of a fiduciary. A fiduciary’s duty of loyalty requires that a plan sponsor act solely in the best interests of the plan participants and their beneficiaries. A fiduciary’s duty of prudence requires that a plan sponsor exercise reasonable care, skill, and caution in managing a plan, specifically with regard to controlling unnecessary costs and risks.

The key question in evaluating annuities, or any other investment, should always be “at what cost?” With annuities, you generally have annual costs as well as additional optional costs for various “bells and whistles.” While costs vary, a basic average annual cost for immediate annuities seems to be 0.7 percent. The average costs for various additional options with all annuities seems to be an additional 1.0 percent. However, it is a plan sponsor’s duty to always ascertain the exact costs.

Plan sponsors need to always remember this mantra – “Costs matter.” Costs do matter, a lot. The General Accounting Office has stated that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a twenty year period. 3

Against that backdrop, plan sponsors are now confronted with the potential issues of including annuities and crypto currencies within a 401(k) plan. I believe that both assets are inappropriate for 401(k) and 403(b) plan sponsors, as well as other investment fiduciaries such as registered investment advisers and trustees and are potential fiduciary liability traps.

Annuities
An exhaustive analysis of annuities is beyond the scope of this post. I simply want to address three of the most common types of annuities and some of the fiduciary issues associated with each. One of the fiduciary issues involved with annuities is their complexity. The analyses herein will be based on the simple, garden variety of each of the three annuities.

1. Immediate Annuities (aka Income Annuities
These annuities are often recommended to provide supplemental income in retirement. In most cases, immediate annuities can be used to provide income for life or for a certain period of time, e.g., 5, 10, 15 or 20 years.

Peter Katt was an honest and objective insurance adviser. During my compliance career, he was my trusted go-to resource. While he passed away in 2015, the lessons I learned from him will always be invaluable. I strongly recommend to investors and investment fiduciaries that they Google his name and read his articles, especially those he wrote for the AAII Journal.

Katt’s thought on immediate annuities include:

The immediate annuity is for people who want the absolute security that they can’t outlive their nest egg. The problem is that there is nothing left over for your heirs.4

While annuities often offer options to address this issue, such options often result in reduced monthly payments and/or additional costs.

Katt always said to get the annuity salesmen to provide a written analysis providing the breakeven analysis for an annuity, the estimated time that would be required for an annuity owner to recover their original investment in the annuity. He told me that breakeven periods of twenty years or more are common, making it unlikely that the annuity owner will ever recover their original investment. And remember, with a life-only immediate annuity, once the annuity owner dies, the balance in the annuity goes to the annuity issuer, not the annuity owner’s heirs.

Katt also said to always ask the annuity salesman for the APR that was used in calculating the breakeven point. The APR is the interest rate that annuity issuers typically use in determining an annuity’s payments.

One of the drawbacks with immediate annuities is that once an interest rate is set, that will be the applicable interest rate for the period of the annuity. Again, some annuities may offer options to avoid this inflexibility…at an additional cost.

The inflexibility of an annuity’s interest rate results in purchasing power risk for an annuity owner. This risk increases as the period of the annuity increases. Purchasing power risk refers to the risk that the annuity’s payments will lose their buying power over the years due to inflation. Some annuities provide for “step-ups” in rates…at an additional cost.

Katt’s advice-anyone considering an immediate annuity should first build a balanced portfolio consisting of stocks and bonds to ensure flexibility, and then invest augment that portfolio with a reasonable am0unt in the immediate annuity. While some annuity salesmen will argue for an “all or nothing” approach in order to maximize their commission. Prudent investors will follow Katt’s advice.

Perhaps the strongest argument against including immediate annuities in 401(k) and other pension plans comes from a study by three well-respected experts on the subject. In analyzing when a Single Premium Immediate Annuity (SPIA), probably the most popular type of immediate annuity, would make sense, the three experts stated that

Results suggest that only when the possibility of outliving 70 percent or more of a cohort exists, and then only at elderly ages. For ages younger than 80, assets are best kept within the family, because both inflation and possible future market returns have time to do better than SPIA lifetime sums.5

Based upon my experience, very few 401(k) plans have plan participants aged 80 or older. I predict that plan sponsors who decide to offer immediate annuities, in any form, in their plans can expect to see that quote again, especially if I am involved in the litigation.

2. Fixed Indexed Annuities (aka Equity Indexed Annuities)
Target date funds (TDFs) are controversial investments that attempt to create investment portfolios that are appropriate based on the investor’s estimated retirement, or target, date. Target date funds have typically designed portfolios consisting of equity and fixed income investments.

There have been reports suggesting that the annuity industry may be trying to include some form of equity indexed annuities (EIAs) as an element in TDFs in 401(k) and 403(b) plans. So, what would be wrong with that? Dr. William Reichenstein, finance professor emeritus at Baylor University sums up the primary issue perfectly.

The designs of equity index annuities (EIAs) and bond indexed annuities ensure that they must offer below-market risk-adjusted returns compared with those available on portfolios of Treasurys and index funds. Therefore, this research implies that indexed annuity salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.6

While EIAs/FIAs are technically insurance products, not securities, Dr. Reichenstein’s analysis is still applicable with regard to a fiduciary’s duties of loyalty and prudence. If the design of these products ensures that they cannot offer competitive returns to those of alternative investments, then how does a plan sponsor, or any fiduciary for that matter, plan to meet their fiduciary duty of loyalty and prudence? Would the inclusion of EIAs in either TDFs, or in 401(k) plans in general. potentially create unnecessary fiduciary liability exposure for plan sponsors or other investment fiduciaries,

As regulators emphasize, before an insurance agent can sell an annuity, he or she must perform due diligence to ensure that the investment offered ex ante competitive returns. Therefore, it is appropriate to compare the net returns available in an equity-indexed annuity to those available on similar-risk investments held outside an annuity.7

[By] design, [equity]indexed annuities cannot add value through security selection ….[T]he hedging strategies [used by equity-indexed annuities] ensure that the individuals buying equity-indexed annuities will bear essentially all the risks. Consequently, all indexed annuities must (ital) produce risk-adjusted returns that trail those offered by readily available marketable securities by their spread, that is, by their expenses including transaction costs.8

Furthermore, by design, indexed annuities typically impose restrictions on the amount of return that an investor can actually receive. Therefore, the combination of the design of these products and the restrictions on returns typically imposed by EIAs/FIAs ensure a fiduciary breach.

So, even though the annuity industry markets these equity indexed annuities by emphasizing stock market returns, the majority of fixed indexed annuity owners are guaranteed to never receive the actual returns of the stock market. While some annuity firms are marketing so-called “uncapped” equity indexed annuities, they may still impose restrictions, and such “uncapped” returns…come with additional costs.

The restrictions and conditions that equity indexed annuities naturally vary. For example, during my time as a compliance director, the equity indexed annuities I saw typically imposed a 8-10 percent cap and a participation rate of 80 percent. What that meant was that regardless of the returns of the applicable market index, with a cap of 10 percent, the most the annuity owner could receive was 10 percent of the index’s return.

As if that was not unfair enough, that 10 percent return was then further reduced by the annuity’s participation rate. So, with a participation rate of 80 percent, the maximum return an investor could receive in our example was 8 percent.

Reichenstein points out even more inequities, noting that  

Because interest rates and options’ implied volatilities change, the insurance firm almost always retains the right to set at its discretion at least one of the following: participation rate, spread, and cap rate.9

And finally, a simple explanation of how equity indexed annuity companies further manipulate returns to ensure that they protect their interests first.

From AmerUS Group financial statements, ‘Product spread is a key driver of our business as it measures the difference between the income earned on our invested assets and the rate which we credit to policy owners, with the difference reflected as segment operating income. We actively manage product spreads in response to changes in our investment portfolio yields by adjusting liability crediting rates while considering our competitive strategies….’ This spread ensures that the annuity will offers noncompetitive risk-adjusted returns.10

I could go on to discuss additional issues such as single entity credit risk and illiquidity risk, but I think investment fiduciaries get the picture. The evidence against equity index annuities establishes that they are a fiduciary breach simply waiting to happen. I strongly recommend that plan sponsors and other investment fiduciaries read Reichenstein’s analysis before deciding to offer fixed indexed annuities, in any shape or form, in their plans or to clients.

3. Variable Annuities
Any fiduciary that sells, uses, or recommends a variable annuity (VA) has probably breached their fiduciary duty…period. Katt summed it up perfectly:

Exhibit A
Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.

[T]he fee [for the death benefit] is included in the so-called Mortality and Expense (M&E) risk charge. The M&E risk charge is a perpetual fee that is deducted from the underlying assets in the VA, above and beyond any fund expenses that would normally be paid for the services of managed money.12

[T]he authors conclude that a simple return of premium death benefit is worth between one to ten basis points, depending on purchase age. In contrast to this number, the insurance industry is charging a median Mortality and Expense risk charge of 115 basis points, although the numbers do vary widely for different companies and policies.13

The authors conclude that a typical 50-year-old male (female) who purchases a variable annuity—with a simple return of premium guaranty—should be charged no more than 3.5 (2.0) basis points per year in exchange for this stochastic-maturity put option. In the event of a 5 percent rising-floor guaranty, the fair premium rises to 20 (11) basis points. However, Morningstar indicates that the insurance industry is charging a median M&E risk fee of 115 basis points per year, which is approximately five to ten times the most optimistic estimate of the economic value of the guaranty.14

Excessive and unnecessary costs violate the fiduciary duty of prudence, especially when they produce a windfall for an annuity issuer at the expense of the annuity owner. The value of a VA’s death benefit is even more questionable given the historic performance of the stock market. As a result, it is unlikely that a VA owner would ever need the death benefit. These two points have resulted in some critics of VAs to claim that a VA owner needs the death benefit like a duck needs a paddle.”

Exhibit B
Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.

At what cost? VAs often calculate a VAs annual M&E charge/death benefit based on the accumulated value within the VA, even though contractually most VAs limit their legal liability under the death benefit to the VA owner’s actual investment in the VA.

This method of calculating the annual M&E, known as inverse pricing, results in a VA issuer receiving a windfall equal to the difference in the fee collected and the VA issuer’s actual costs of covering their legal liability under the death benefit guarantee.

As mentioned earlier, fiduciary law is a combination of trust, agency and equity law. A basic principle of fiduciary law is that “equity abhors a windfall.” The fact that VA issuers knowingly use the inequitable inverse pricing method to benefit themselves at the VA owner’s expense would presumably result in a fiduciary breach for fiduciaries who recommend, sell or use VAs in their practices or in their pension plans.

The industry is well aware of this inequitable situation. John D. Johns, a CEO of an insurance company, addressed these issues in an article entitled “The Case for Change.”

Another issue is that the cost of these protection features is generally not based on the protection provided by the feature at any given time, but rather linked to the VA’s account value. This means the cost of the feature will increase along with the account value. So over time, as equities appreciate, these asset-based benefit charges may offer declining protection at an increasing cost. This inverse pricing phenomenon seems illogical, and arguably, benefit features structured in this fashion aren’t the most efficient way to provide desired protection to long-term VA holders. When measured in basis points, such fees may not seem to matter much. But over the long term, these charges may have a meaningful impact on an annuity’s performance.15

In other words, inverse pricing is always a breach of a fiduciary’s duties of both loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without any commensurate return, which would presumably violate Section 205 of the Restatement of Contracts.

Exhibit C
Benefit – VAs allow their owners the opportunity to invest in the stock market and increase their returns.

VAs offer their owners an opportunity to invest in equity-based subaccounts. Subaccounts are essentially mutual funds, usually similar to the same mutual funds that investors can purchase from mutual fund companies in the retail market.

While there has been a trend for VAs to offer cost-efficient index funds as investment options, many VA subaccounts are essentially same overpriced, consistently underperforming, i.e., cost-inefficient, actively managed mutual funds offered in the retail market. As a result, VA owners’ investment returns are typically significantly lower than they would have been when compared to returns of comparable index funds.

Exhibit D
Benefit – VAs provide tax-deferral for owners.

So do IRAs. So do any brokerage account as long as the account is not actively traded. However, dividends and/or capital gain distributions are taxed when they occur.

The key point here is that IRAs and brokerage accounts usually do not impose the high costs and fees associated with annuities. This is especially true of VAs, where annual fees of 3 percent or more are common, even higher when riders and/or other options are added.

Remember the earlier 1/17 note? Multiply 3 by 17 to see the obvious fiduciary issues regarding the fiduciary duties of loyalty and prudence. 

Although not an issue for plan sponsors, another “at what cost” fiduciary issue for other investment fiduciaries has to do with the adverse tax implications of investing in non-qualified variable annuities (NQVA). Non-qualified variable annuities are essentially those that are not purchased within a tax-deferred account, e.g., a 401(k)/403(b) account, an IRA account.

When investors invest in equity investments, they typically are not taxed on the capital appreciation until such gains are actually realized, such as when they sell the investment or, in the case of mutual funds, when the fund makes a capital gains distribution.

In many cases, investors can reduce any tax liability by taking advantage of the special reduced tax rate for capital gains. However, withdrawals from a NQVA do not qualify for the lower capital gains tax. All withdrawals from a NQVA are considered ordinary income, and thus taxed at a higher rate than capital gains. An investment that increases its owner’s tax liability by converting capital gains into ordinary income is hardly prudent or in an investor’s “best interest.”

Bottom line – there are other less costly investment alternatives available that provide the benefit of tax deferral. While they may not offer the same guaranteed income, they provide other significant benefits, while avoiding some of the fiduciary liability risks associated with VAs, e.g., reduced flexibility, purchasing power risk, higher taxes.

Exhibit E
Benefit: Annuity owners do not pay a sales charge, so more of their money goes to work for them.

The statement that variable annuity owners pay no sales charges, while technically correct, is misleading. Variable annuity salesmen do receive a commission for each variable annuity they sell. Commissions paid on VA sales are typically among the highest paid in the financial services industry.

While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through a variable annuity’s various fees and charges.

To ensure that the cost of commissions paid is recovered, the annuity issuer typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for a specific initial surrender charge during the first year, then decreasing 1 percent each year thereafter until the eighth year, when the surrender charges would end. There are some surrender charge schedules that charge a flat rate over the entire surrender charge period.

Cryptocurrency
Fidelity Investments recently announced that it would begin offering a new fund that would allow 401(k) plans to offer a cryptocurrency option within the plan. The reaction was immediate and divided. News that Bitcoin and other cryptocurrencies have suffered a significant loss are almost a daily event.

Since there are still a number of issues that need to be address ed, especially the concerns raised by regulators, including the Department of Labor16 and the Securities & Exchange Commission17, I will simply suggest that plan sponsors and other investment fiduciaries should wait until the regulators have issued guidelines on this topic.

One thing I will address is the notion that because investors may want to invest in cryptocurrency is no reason for a plan sponsor or other investment fiduciary to do so. First, a plan sponsor has no obligation, legal or otherwise, to include any investment option in a plan simply because one or more plan participants want to invest in such an option. A plan sponsor, a trustee, or any other investment fiduciary has two primary duties, the duty of loyalty and the duty of prudence.

With all the acknowledged concerns about cryptocurrency, from susceptibility to hacked accounts resulting in significant losses, the volatility of such investments, and questions regarding the concept/ structure of such investments, prudence is the best course for all fiduciaries at this point. For plan participants that want to invest in cryptocurrencies, they are free to open up retail brokerage accounts and trade in such investments.

Going Forward
Ever since Fidelity made its announcement regarding cryptocurrency, I have been asked by clients and the media for my opinion on what I see for fiduciary law and 401(k) litigation. My answer-an increase in litigation.

What too many plan sponsors fail to recognize and appreciate is the fact that those recommending investment products generally are not doing so in a fiduciary capacity and therefore arguably have no potential fiduciary liability. Plan sponsors, trustees and other investment fiduciaries that follow such advice will typically have unlimited personal liability exposure.

Plan sponsors and other investment fiduciaries have a duty to independently investigate, evaluate, select and monitor the investment options they select or recommend.

  • Over and above its duty to make prudent investments, the fiduciary has a duty to conduct an independent investigation of the merits of a particular investment….A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.18 
  • 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.19 
  • A determination whether a fiduciary’s reliance on an expert advisor is justified is informed by many factors, including the expert’s reputation and experience, the extensiveness and thoroughness of the expert’s investigation, whether the expert’s opinion is supported by relevant material, and whether the expert’s methods and assumptions are appropriate to the decision at hand. One extremely important factor is whether the expert advisor truly offers independent and impartial advice.

Defendants relied on FPA, however, and FPA served as a broker, not an impartial analyst. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best. A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative.   FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of “can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce.20 

These fiduciaries duties are inviolate. There are no “mulligans” or “do overs” in fiduciary law. As the courts have repeatedly pointed out, “A pure heart and an empty head’ are no defense to allegations of the breach of one’s fiduciary duties.21

If anything positive comes out of the current debate over the inclusion of annuities and/or cryptocurrencies in 401(k) plans, hopefully it will be a greater recognition and appreciation of the importance of one’s fiduciary duties by plan sponsors and other investment fiduciaries.

Plan sponsors and other investment fiduciaries considering offering/recommending annuities and/or cryptocurrency need to always remember three basic rules of fiduciary law:

1. There are no “mulligans” or “take overs” in fiduciary law.
2. There is no balancing of good versus bad features/acts in fiduciary accounts. Fiduciary errors are strictly “one and done.”
3. Courts in fiduciary cases often admonish defendant fiduciaries that “a pure heart and an empty head” are no defense to claims of a fiduciary breach

Resources
There are a number of resources available online that can be used to analyze annuities in terms of breakeven analysis. Google “annuity breakeven analysis” to find them. In my practice, I often use the Annuity Break-Even Calculator — VisualCalc program, which compares an annuity with an alternative equity investment. The graphic makes the results easier to understand.

The article by Frank, Mitchell, and Pfau provides detailed instructions on how to perform annuity breakeven analyses using Microsoft Excel.

Notes
1. Meinhard v. Salmon, 249 N.Y. 458, 464 (1928).
2. Tibble v. Edison International, 135 S. Ct 1823 (2015).
3. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”). http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”), http://www.gao.gov/new.item/d0721.pdf
4. Peter C. Katt, “The Good, Bad, and Ugly of Annuities,” AAII Journal, November 2006, 34-39
5. Larry R. Frank, Sr., John B. Mitchell, and Wade Pfau, “Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios,” Journal of Financial Planning, April 2014, 38-47. 8. Reichenstein, 302.
9. Reichenstein, 303.
10. Reichenstein, 309.
11. Katt, 35.
12. Moshe Miklevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126, 92.
13. Milevsky and Posner, 94.
14. Milevsky and Posner, 122.
15. John D. Johns, “The Case for Change,” Financial Planning, September 2004, 158-168.
16. Department of Labor, “Compliance Assistance Release No. 2022-01”
17. https://www.sec.gov/speech/gensler-remarks-crypto-marketds-040422.
18. Fink v. National Saving & Loan, 772 F.2d 951 (D.C. Cir. 1985); Donovan v. Cunningham, 716 F.2d 1455, 1467; Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981).
19. Liss v. Smith, 991F.Supp. 278 (S.D.N.Y. 1998).
20. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003)
21. Cunningham, 1461.

© Copyright 2022 InvestSense, LLC. 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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Heuristics, Cognitive Biases and 401(k)/403(b) Fiduciary Decision-Making

Posted on April 24, 2022 by jwatkins

The number of 401(k)/403(b) cases continues to grow. And it will continue to do so unless and until plan sponsors take the time to truly understand their legal responsibilities and adjust their plans accordingly. 

I am on record as saying that plan participants should never lose a 401(k)/403(b) breach of fiduciary action if their attorneys properly plead their action. After the recent SCOTUS decision in Hughes v. Northwestern University (Northwestern), that opinion has only grown stronger. 

First, the Northwestern, decision is the final piece of what I have termed the “fiduciary responsibility trinity” (Trinity). Together with the earlier decisions in Tibble v. Edison International and Brotherston v. Putnam Investments, LLC, the Northwestern decision provides a simple blueprint for both effectively litigating 401(k)/403(b) actions and for preventing such actions. 

Second, the fiduciary breach actions continue to demonstrate that plan sponsors simply do not understand what their fiduciary responsibilities truly are and how easy it is to comply with same to avoid unnecessary and unwanted fiduciary liability exposure. 

In college, my minor was psychology. My thesis was on heuristics, cognitive biases and the decision-making process. I have always been fascinated by the way the mind works.  

As I monitor the ongoing legal developments regarding fiduciary liability, I am amazed at the failure, or refusal, of fiduciaries to simplify their responsibilities by focusing on creating “win-win” plans, plans which are in the plan participants’ best interests while protecting the plan sponsor from legal liability. 

Nobel Laureate Daniel Kahneman’s best seller, “Thinking Fast and Slow,” offers a valuable insight into why the fiduciary liability crisis exists and how it can be avoided. Click here to view a 2-minute analysis of Kahneman’s thoughts. 

When I created the Active Management Value Ratio™ (AMVR) metric, it was based on these same principles and how the metric could help both fiduciaries and attorneys address the current fiduciary responsibility disconnect. 

Heuristics and Cognitive Biases 
Let me begin by saying that what I am about to write is neither intended to, nor does, provide a detailed discussion. For those desiring to learn more about the subject, especially in connection with investing, simply search online using the search term, “heuristics and investment decision-making.” There are plenty of interesting articles addressing the issue. 

Heuristics are essentially mental shortcuts that we take in making decisions. The bat/paddle and ball analogy is an excellent example of how we use heuristics to simplify the decision-making process, the intuitive or “fact thinking” process. 

The problem that a decision-maker must consider is that heuristics can often result in errors due to the influence of cognitive biases that may influence a decision-maker’s judgment. Common cognitive biases that influence decisions include  

  • Confirmation bias – the tendency to give greater weight to information that confirms our existing beliefs. 
  • Anchoring bias – the tendency to put greater emphasis on and credibility to the first piece of information that we hear. 
  • “Halo effect” – the tendency for an initial impression of a person to influence the overall and ongoing opinion we have of them. 

Based upon my experience, these three cognitive biases often come into play in the fiduciary decision-making process. The most notable example of this is the refusal of plan sponsors to listen to anyone other than their existing plan advisers and their refusal to consider alternative options. 

Heuristics and the Active Management Value Ratio™ 
As I mentioned, heuristics and cognitive biases were a primary consideration when I created the AMVR metric.  As the video points out, the impact/influence of large numbers is a well-known cognitive bias. 

What would be your initial reaction if I were to recommend this investment option for your 401(k)/403(b) plan? 

22.73 percent return with an expense ratio of 78 basis points. 22.73 vs. 0.78. The immediate, intuitive reaction would most likely be very positive. 

Now, what would be your reaction if you were presented with the following AMVR forensic analysis slide? 

Hopefully, a plan sponsor’s rational, “slow thinking” decision-making side would quickly convince them that Fidelity Contrafund is not the optimum choice for their plan relative to the comparable index fund. Again, an optimum choice would be one which advances the best interests of plan participants and protects a plan sponsor against unnecessary and unwanted fiduciary liability exposure. 

Unfortunately, the continuing increase in 401(k) /403(b) actions and multi-million-dollar settlements suggests that too many plan sponsors are using an intuitive, “fast thinking approach to fiduciary decision-making instead of a rational, “slow thinking” approach, resulting in greater liability exposure.  

Going Forward  
I recently gave a presentation of my new concept, “The 401(k) Fiduciary Responsibility Blueprint™” to several investment fiduciaries. The concept combines my “fiduciary responsibility trinity” and “fiduciary prudence trinity” concepts with the impact of heuristics and cognitive biases on the fiduciary decision-making process. 

To be honest, I was somewhat surprised, but encouraged, by the overwhelmingly positive response, with several attendees asking for follow-up sessions. While 401(k)/403(b) litigation continues to receive the most attention, the issues discussed herein apply to all investment fiduciaries. Unless and until investment fiduciaries acknowledge and address these decision-making shortfalls, they will continue to be targets for fiduciary litigation actions.   

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary standard, investments, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , | Leave a comment

CommonSense 401(k) Prudence and Risk Management

Posted on April 11, 2022 by jwatkins

Whenever I perform a forensic fiduciary advice on a 401(k) or 403(b) plan, I invariably find myself asking the plan sponsor and/or the plan’s investment committee the same two questions:

  1. Why do you have so many investment options?
  2. Why did you choose these specific investment options?

I typically one or some combination of the following three responses:

  1. “We were told that it was important to provide plan participants with ‘choices’.”

Providing plan participants with meaningful investment options is very important. However, most 401(k)/403(b) plans are dominated by actively managed mutual funds. Studies have consistently shown that the overwhelming majority of actively managed mutual funds are not cost-efficient and, therefore, are legally imprudent for pension plans. A cost-inefficient, legally imprudent investment options is not a “choice” for plan participants. It is fiduciary liability exposure for a plan and its fiduciaries.

2. “We were told that we could reduce our risk of being sued by offering a large number of investment options.”

Ah yes, the infamous “menu of options” argument. That argument was officially discredited by the Supreme Court’s recent Hughes v. Northwestern University decision. The Court, citing ERISA itself, ruled that each individual investment option within a 401(k) plan must be legally prudent. So the “menu of options” never had any legal legitimacy since ERISA provides otherwise. Nevertheless, many 401(k) plan that relied such faulty advice are now finding themselves in a difficult legal situation.

3. “We thought the more investment options we offered, the greater the odds of successful investing.”

Again, cost-inefficient investment options are not a legitimate investment “choice,” as their incremental costs exceed their incremental returns when evaluated against a comparable index fund. This answer also illustrates a lack of understanding as to what a plan sponsor’s fiduciary duties requires.

A plan sponsor is not required to guarantee the ultimate performance of the investment options chosen for a plan. Nobody can do that. Plan sponsors are only required to select legally prudent investment options for the plan participants by using a sound due diligence process.

Where many plan sponsors create unnecessary liability exposure for themselves is in following the advice of plan advisers and other third parties. While ERISA does allow, even recommend, that plans hire experts to help them if they lack the knowledge or experience to select prudent investment options for the plan, ERISA and the courts have consistently pointed out that (1) any reliance on such third-parties must be reasonable, and (2) the plan sponsor cannot blindly rely on advice from such third-parties, the plan sponsor must still perform a personal investigation and evaluation of all prospective investment options.

So, what constitutes “reasonable reliance?” The courts have ruled that reliance on third-parties that may be biased or otherwise influenced by potential or actual conflicts of interest is not considered reasonable.

  • “Over and above its duty to make prudent investments, the fiduciary has a duty to conduct an independent investigation of the merits of a particular investment….A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.” Fink v. National Saving & Loan, 772 F.2d 951 (D.C. Cir. 1985): Donovan v. Cunningham, 716 F.2d 1455, 1467; Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981)
  • “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.” Liss v. Smith, 991F.Supp. 278 (S.D.N.Y. 1998)
  • “While a plan sponsor may hire an adviser or other expert, [t]he fiduciary must (1) ‘investigate the expert’s qualifications’;  (2) ‘provide the expert with complete and accurate information’;  and (3) ‘make certain that reliance on the expert’s advice is reasonably justified under the circumstances.’”

“A determination whether a fiduciary’s reliance on an expert advisor is justified is informed by many factors, including the expert’s reputation and experience, the extensiveness and thoroughness of the expert’s investigation, whether the expert’s opinion is supported by relevant material, and whether the expert’s methods and assumptions are appropriate to the decision at hand. One extremely important factor is whether the expert advisor truly offers independent and impartial advice.” (emphasis added)

“Defendants relied on FPA, however, and FPA served as a broker, not an impartial analyst. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best.   A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative.   FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of “can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce. ” Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003)

  • “In determining compliance with ERISA’s prudent man standard, courts objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions.”

    “[F]iduciaries in other circumstances, are entitled to rely on the advice they obtain from independent experts. Those fiduciaries may not, however, rely blindly on that advice.” Bussian v. RJR Nabisco, Inc., 223 F.3d 286, 298-300 (5th Cir. 2000)

When I inform plan sponsors of these legal standards, they often respond by saying that it was their inability to perform such investigations and evaluations that led them to seek third-party advice. And that is obviously a valid point. In fact, that is one of the primary reasons why Rick Ferri, Chris Tobe and I co-founded the “CommonSense 401(k) Project,” (Project) to provide a resource that plan sponsors could turn to for experienced, (almost 100 years of combined experience) and objective advice.

The good news for plan sponsors and plan investment committees is that designing, implementing and maintaining a win-win 401(k) or 403(b) plan, one that truly provides both effective investment “choices” for plan participants and protects a plan’s sponsor and investment committee is actually quite simple and cost-effective.

After we talk to a plan about the Project’s concepts, the usual response is “why didn’t our plan adviser simplify the process like this?” While I have my theories, my advice is usually to ask them.

Many plans have asked me whether plan advisers should be required to support their investment recommendations with an Active Management Value RatioTM (AMVR) forensic analysis. Obviously, I am biased, since I created the metric. Then again, if the goal is to provide a plan and it participants with the best service and advice…why not? Even more important, plan sponsors and the plan’s investment committee should learn the AMVR methodology so they can perform the legally required investigation and evaluation.

For more information about the #CommonSense401kProject, visit our site at http://commonsense401kproject.

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1Q 2022 AMVR “Cheat Sheets”

Posted on April 1, 2022 by jwatkins

On the 5-year cheat sheet, only one fund, Dodge & Cox Stock (DODGX), posted positive incremental returns on both nominal and risk-adjusted returns. While DODGX passed the AMVR screen on nominal returns, the fund failed to pass the AMVR screen on a risk-adjusted basis due the combination of a relatively high standard deviation (15.99) and a high r-squared/correlation number (97), resulting in an extremely high correlation -adjusted/Active Expense Ratio score (8.77).

InvestSense calculates AMVR using a fund’s correlation-adjusted incremental costs (using Ross Miller’s Active Expense Ratio metric) and risk-adjusted incremental returns (using Morningstar’s risk-adjusted return methodology), based upon the belief that such data provides a more accurate evaluation of a fund’s prudence.

The same results hold true on the 10-year AMVR cheat sheet. The results on both cheat sheets illustrate the importance of factoring in r-squared/correlation of returns. Using DODGX as an example, its r-squared of 97 suggests that a fiduciary could achieve 97 percent of DODGX’s return for the much lower cost of the benchmark index fund, in this case Vanguard’s Large Cap Growth Index Fund, Admiral shares. As a result, a fiduciary would be effectively paying a much higher expense ratio for the risk-adjusted incremental return, as shown in both charts.

The data shown covers the respective time periods, ending on 3/31/2022. The benchmarks used are the Admiral shares of the Vanguard funds comparable to the referenced funds’ Morningstar asset category: Vanguard Large Cap Growth Index Fund (VIGAX), Vanguard Large Cap Value Index Fund (VVIAX), and Vanguard Large Cap Blend Index Fund (VFIAX).

Posted in 401k, 401k compliance, Active Management Value Ratio, cost efficient, cost-efficiency, DOL fiduciary standard, ERISA, fiduciary duty, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, pension plans | Tagged , , , , , | Leave a comment

Less Is More: Plan Sponsors and the Art of Fiduciary Thinking

Posted on March 30, 2022 by jwatkins

When I read about the House passing the SECURE 2.0 bill, I had three immediate thoughts:

  • “Annuities are sold, not bought.”
  • “So, plan sponsors are going to be able to automatically force employees to contribute to non-compliant 401(k) plans loaded with cost-inefficient, legally imprudent actively managed mutual funds.”
  • “It’s a fiduciary trap.”

It’s the third point I want to focus on in this post. SCOTUS recently addressed the impropriety of 401(k) plans combining prudent and imprudent investment options within a plan.

Now, plans are being advised to unilaterally insert defensive clauses into their plans in an effort to reduce 401(k) and 403(k) litigation. Given the fact that such clauses would obviously only benefit the plan, it would seem that such strategies would blatantly violate the plan sponsor’s fiduciary duty of loyalty, the duty to act exclusively in the best interests of the plan participants and their beneficiaries.

As for SECURE 2.0, forcing employees to contribute to a non-compliant ERISA plan raises obvious legal liability questions. As for allowing annuities, in any form, in 401(k) plans, the is indefensible, as will be discussed later.

As a former securities and RIA compliance director, I am well-acquainted with the financial services’ saying-“annuities are sold, not bought”–and the truth behind the saying and reasons for same. The annuities industry has continually attempted to get RIAs and 401(k) plans to embrace their products. Smart investment fiduciaries have refused to fall into the liability trap that annuities pose for fiduciaries.

Fiduciary law is a combination of three types of law–trust, agency and equity. The fundamental concept of fiduciary law is fundamental fairness.

SCOTUS has consistently recognized the fiduciary principles set out in the Restatement (Third) of Trusts (Restatement) as guidelines for fiduciary responsibility and prudence. The two consistent themes throughout the Restatement are cost-efficiency and risk management through diversification.

I am 67, so I remember the famous “Pogo” cartoon strip where Pogo says “we have met the enemy…and he is us!” In far too many instances, that sums up the current fiduciary liability crisis involving plan sponsors. I honestly believe that most plan sponsors have good intentions. The problem is that they continue to listen to the wrong parties and blindly rely on such parties’ advice, even though the courts have consistently stated that such blind reliance on third-party advice is a per se breach of their fiduciary duties.

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. Liss v. Smith, 991, F. Supp. 278, 297 (S.D.N.Y. 1988)

So, this is not a new requirement that should come as a surprise to 401(k) plan sponsors. In my conversations with plan sponsors during audits and casual conversations, they obviously are aware of the requirement and the consequences for non-compliance. The problem–they consistently admit that they do not know how to perform the required investigation and evaluations.

Plan sponsors are saying that they have never been trained to think like a fiduciary. The obvious question is “why.” Why have plan advisers not taught them how to perform he required fiduciary procedures? Is it to prevent plan sponsors from being able to assess the true value, or lack thereof, of the services that their plan advisor provides? Is it a self-serving strategy by plan advisers to try to justify their high fees with unnecessarily complex and confusing plans?

Whatever the reason, why have plan sponsors not taken the initiative to find someone to teach them what the applicable law is, how to use that law to design a legally compliant decision-making process rather than constantly exposing themselves the unnecessary fiduciary liability/ Trust me, 401(k) litigation is only going to get worse.

I was a PoliSci major in college. However, my minor was psychology, with a concentration in cognitive psychology, the study of decision-making. The human mind continues to fascinate me.

Most people know Annie Duke as a champion poker player. What most people do not known is that Annie has an M.B.A. in cognitive psychology. She now practices as a decision strategist. She has written two excellent books on the decision-making process, “Thinking in Bets” and “How to Decide.” Her third book, “Quit,” comes out this Fall.

Annie’s message is simple and direct: the quality of our lives depends on the quality of our decisions and luck.  In “How We Decide,” Annie discusses the value of quit-to-itiveness, the value of realizing that change is needed and can be a positive move,

When I created the Active Management Value Ratio (AMVR) metric, part of the reasoning was to help teach investment fiduciaries how to avoid unnecessary fiduciary risk by thinking like a fiduciary, how to simplify the fiduciary prudence process. The other part of the reasoning, honestly, was to help fellow ERISA plaintiff attorneys expose ERISA non-compliant 401(k) and 403(b) plans.

I figured attorneys would listen to the rationale behind the metric. They have. I figured that plan sponsors, trustees and other investment fiduciaries would not listen. I was right.

With the Hughes v. Northwestern University decision and the resulting “fiduciary responsibility trinity” of Hughes, Tibble v. Edison International, and Brotherston v. Putnam Investments, LLC, plan sponsors and other investment fiduciaries are clearly at the crossroads, as it is time to “fish or cut bait.” Again, 401(k)/403(b) litigation is not going away. To be honest, the cases are simply too easy to win or settle as long as they are properly plead.

For example, if I were to present this AMVR forensic analysis to you as a plan advisor, what would you decide-prudent or imprudent?

Nobel laureate Dr. William Sharpe has offered the following advice for analyzing the prudence of mutual funds:

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

Noted wealth management expert, Charles D. Ellis, goes further, stating that

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

So, analyzing the AMVR forensic analysis as a fiduciary using the following guidelines, would you deem the actively managed fund to be prudent or imprudent?

The actively managed fund is clearly an imprudent investment for a fiduciary, or anyone else for that matter, relative to the benchmark used, the Vanguard Large Cap Growth Index Fund (VIGAX). Yet the actively managed fund shown, Fidelity Contrafund Fund, K shares (FCNKX), is consistently in the top five funds in U.S. domestic 401(k) plans. Common sense should indicate that any fund whose incremental costs exceed their incremental return, when cost exceed benefits, is imprudent.

So, what about annuities. I wrote a lengthy post on the issue of variable annuities https://investsense.com/2021/04/21/variable-annuities-reading-between-the-marketing-lines/. The high costs associated with annuities and the potential loss of one’s life’s savings to the annuity issuer rather than one’s heirs are negatives often associated with annuities.

Annuities within 401(k) plans add yet another issue, the possibility that the 401(k) may be forced to annuitize an annuity in order to make the required minimum distributions required on retirement accounts. Once an annuity owner annuitizes the annuity, the annuity issuer, not the annuity owner, owns and controls the funds in the annuity. Some annuities are so determined to get their hands on the funds in an annuity that they force the annuity owner to annuitize at a certain age. 

As Annie would say, annuities are essentially a bet. The annuity company calculates your life expectancy and bases payments accordingly. The annuity is betting that you will die sooner than projected, resulting in a cash “windfall” for them. Same goes if the annuity owner chooses a life/survivor option, in which case the payments to the annuity owner and survivor are reduced to factor in the combined life expectancy. Again, the annuity issuer is betting that the owner and the survivor will die earlier than estimated, leaving a cash “windfall” in the annuity for the issuer, not any heirs.

Whenever I perform a 401(k) fiduciary audit, I talk to the plan sponsor and investment committee to determine just how well they understand their fiduciary duties. In most cases, not very well, if at all. As I mentioned earlier, in most cases they just blindly accept whatever their plan adviser of some other third-party tells them.

“Retirement readiness” is a buzzword often heard in connection with 401(k) and 403(b) plans. Plan sponsors and investment committees often tell me that means they need to ensure the performance of the investment options chosen for their plan. I then explain to them that they simply cannot ensure such results; that their only fiduciary duty is to perform the required independent investigation and evaluation and use a prudent process to select the fund’s investment options.

I always enjoy the reaction when I explain to a plan sponsor and an investment committee just how easy it is to design, implement and maintain an ERISA compliant 401(k)/403(b) plan. Rick Ferri, Chris Tobe and I recently established the “CommonSense 401(k) Project’ for the purpose of explaining just how simple and cost-efficient operating an ERISA compliant 401(k) plan can, and should, be.

Plan sponsors and investment committees are amazed when I explain that ERISA compliant 401(k) plans can be designed with as few as 3-5 prudently selected investment options. No more confusing 20-30 investment option plans, no more “paralysis by analysis.” This generally makes the required fiduciary duty of ongoing monitoring process easier, reduces costs, and potentially increases employee participation due to the simplicity of participating in the plan.

Going Forward
Assuming that SECURE 2.0 becomes law, 401(k) plan sponsors and investment committees face some significant decisions, decisions which could easily expose both the sponsor and investment committee to unnecessary fiduciary liability exposure. To avoid such situations, plan sponsors and investment committees need to learn and understand the applicable laws and learn how to think like investment fiduciaries. By doing so, they can create a win-win 401(k) plans, a situation where “less is more” is actually legally compliant. For further information and to schedule a free consultation, visit https://commonsense401kproject.com

Posted in 401k, 401k compliance, 401k investments, Active Management Value Ratio, Annuities, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary standard, pension plans, prudence | Tagged , , , , , | Leave a comment

Connecting the Dots: Correlation of Returns and Fiduciary Prudence

Posted on March 19, 2022 by jwatkins

With SCOTUS’ recent decision in Hughes v. Northwestern University1, we now have what I like to refer to as the “fiduciary responsibility trinity” (Trinity). The Trinity consists of the Tibble v. Edison International2 (Tibble), Brotherston v. Putnam Investments, LLC3(Brotherston), and Hughes/Northwestern decisions.

I recently reviewed the relevant language from each decision in a post on a sister blog, the “CommonSense 401(k) Project.”4 To summarize:

Hughes/Northwestern ruled that a plan sponsor has a fiduciary duty to ensure that each investment option within a plan is prudent and to remove any that are not.

Tibble recognized the Restatement of Trusts (Restatement) as a legitimate resource in resolving fiduciary issues and ruled that a plan sponsor has an ongoing fiduciary duty to monitor plan investment options for prudence.

Brotherston ruled that comparable index funds can be used for benchmarking purposes, citing Section 100 of the Restatement.

The question that I am constantly asked by plan sponsors and other investment fiduciaries, as well as attorneys, is “so how do I use all this to evaluate the fiduciary prudence of an investment option?” Obviously, my first response is to use InvestSense’s proprietary metric, the Active Management Value RatioTM (AMVR) to evaluate the investment’s cost-efficiency. But I also suggest that they look at the “AER” column and calculate the investment’s incremental costs using that number>

Why? “AER” stands for Ross Miller’s Active Expense Ratio (AER) metric. The AER uses a mutual fund’s r-squared, or correlation of returns, number to calculate a fund’s effective expense ratio. Based on the AER, Miller found that investors in actively managed mutual funds effectively pay expense ratios 400-500 percent higher than the fund’s publicly expense ratio.

So why calculate an actively managed fund’s correlation-adjusted expense ratio? As Miller explains,

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs 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.5

Martijn Cremers, creator of the Active Share metric, goes further, stating that actively managed mutual funds are arguably guilty of investment fraud.

[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….

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.6

And there it is-“closet indexing.” Closet indexing has become an international issue for the very reasons stated above. Closet indexing refers to a situation where a fund charges a high expense ratio, citing the benefits of the fund’s active management. However, the fund shows a high correlation of returns to a much less expensive, comparable index fund with the same, or better, returns.

Financial advisers and actively managed mutual funds do not like to talk about the costs associates with their funds. Research has consistently shown that the overwhelming majority of actively managed are not cost efficient.

  • 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
  • [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.10

Cost-consciousness, or cost-efficiency is a constant theme throughout the Restatement. Three comments in Section 90, also known as the Prudent Investor Rule, contains three comments that could, and should, define prudence in future ERISA excessive fees/breach of fiduciary duty actions.

  • A fiduciary has a duty to be cost-conscious. (Introductory Section to Section 90)
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return. (cmt. f)
  • Actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent. (cmt. h(2).

Actively managed mutual funds with high r-squared scores relative to comparable, less costly, index funds are potential candidates for “closet index” fund status. While there is not a universally designated r-squared number for “closet fund” status, most people agree that an r-squared number of 90 or above is a indication that a fund is a “closet index,” aka “index hugger” fund. Morningstar uses an even lower r-squared score of 80.

Over the past decade, the overwhelming majority of actively managed U.S. domestic equity funds have shown an r-squared of 90 or above relative to comparable index funds. The fund used in the AMVR forensic analysis shown below had an r-squared score of 98 relative to the benchmark index fund. The analysis is a perfect example of the potential impact of a fund’s high r-squared score on both its effective expense ratio and resulting cost-efficiency.

Closet index status indicates that an investor could achieve the same, in many cases better returns, at a much lower cost. Cost-inefficient investments waste plan participants’ money. As the Uniform Prudent Investor Act states, “Wasting beneficiaries’ money is imprudent.”11

Going Forward
The Hughes/Northwestern and the resulting “fiduciary responsibility trinity” have raised a plan sponsor’s fiduciary’s duty of prudence to an even higher level than before. In assessing the prudence of a plan’s potential or actual investment option, do plan sponsors, for that matter any investment fiduciary, have a duty to address whether a mutual fund qualifies as a “closet index” fund? Should they have such a duty in order to protect plan participants and other beneficiaries given the obvious harm of “closet indexing?” Is factoring in funds’ r-squared scores/correlations of returns the “next big thing” in 401(k) and fiduciary investment prudence litigation?

Notes
1. Hughes v. Northwestern University, 19-1401 (January 24, 2022).
2. Tibble v. Edison International, 135 S. Ct 1823 (2015).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
4. https://commonsense401kproject.com.
5. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
6. 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.
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, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
9. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
10. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
11. Uniform Prudent Investor Act (UPIA), Section 7 (Introduction).

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, closet index funds, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, pension plans, prudence, wealth management, wealth preservation | Tagged , , , , , , , , , , , | Leave a comment

The “Fiduciary Prudence Trinity”: A Blueprint for Evaluating the Prudence of Fiduciary Investments

Posted on March 17, 2022 by jwatkins

In my last post, I discussed the significance of three ERISA related decisions-Tibble, Hughes/Northwestern and Brotherston. I like to refer to these three cases as the “fiduciary responsibility trinity,” because I believe that, collectively, they will shape the future of 401(k)/403(b) litigation by providing a “blueprint” for both plan sponsors and ERISA attorneys.

The “fiduciary responsibility trinity” provides a macro blueprint for 401(k)/403(b) litigation. The “fiduciary prudence trinity” (Trinity) provides the micro blueprint for 401(k)/403(b) litigation, a means of evaluating the prudence of a plan’s actual investment options.

The cornerstone of my fiduciary compliance consulting practice is InvestSense’s proprietary metric, the Active Management Value Ratio (AMVR). The AMVR evaluates the cost-efficiency of actively managed mutual funds relative to comparable index funds. While many actively managed funds compare their performance to a comparable market index, market indices do not allow for cost-efficiency analyses since indices do not have costs. That is why the AMVR uses comparable index funds, as such funds do have costs similar to actively managed mutual funds.

In Tibble, SCOTUS recognized the Restatement (Third) of Trusts (Restatement) as a valuable resource in addressing fiduciary issues. The fiduciary prudence trinity is based on three key provisions of section 90 of the Restatement, otherwise known as the “Prudent Investor Rule.”

The common law of trusts ‘offers a starting point for analysis of ERISA….’ 1

[R]ather than explicitly enumerating all of the powers and duties of trustees and other fiduciaries, Congress invoked the common law of trusts to define the general scope of their authority and responsibility.”2

Thus, a federal common law based on the traditional common law of has developed and is applied to define the powers and duties of ERISA plan fiduciaries….3

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

  • A fiduciary has a duty to be cost-conscious. (Introductory Section to Section 90)
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return. (cmt. f)
  • Actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent. (cmt. h(2).

The AMVR provides a quick and simple means of addressing each of the three points. Fidelity Contrafund and American Funds’ Growth Fund of America are two popular investment options in U.S. defined contributions plans. Based on the AMVR analyses shown below, should plan sponsors reconsider the inclusion of the funds?

In analyzing the results of an AMVR forensic analysis, the two primary questions are:

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

If the answer to either of the two questions is “no,” then the actively managed fund is imprudent compared to the benchmark index fund. It’s just that simple. Simple subtraction and division.

In the analyses shown above, both Fidelity Contrafund and Fund of America would be deemed imprudent since neither fund produced a positive incremental return relative to the benchmark fund. A plan sponsor, at a minimum, should consider placing such funds on a “watch” list and continue to monitor the funds.

InvestSense bases its analyses on quarterly returns. Obviously, such returns and analyses results are subject to change. The analyses shown above are based on the 5-year returns of each fund, for the period ending December 31, 2021. When InvestSense does a forensic analysis, we provide an analysis for both the most recent 5 and 10-year period in order to assess consistency of performance.

While it was unnecessary in this case to consider the correlation-adjusted incremental costs of either fund, it should be noted that both funds had an r-squared score of 98. Such costs are shown under the AER column, reflecting InvestSense’s use of Ross Miller’s Active Expense Ratio metric. Obviously, had the funds’ AMVR analyses been based on their AER numbers, their level of imprudence would have been even worse.

Going Forward
The 401(k)/403(b) industry has been changed forever, especially with regard to litigation. While ERISA plaintiff attorneys must still make sure their pleadings meet SCOTUS’ plausibility standard, their job has been made seemingly easier with both the Hughes/Northwestern decision and the resulting “fiduciary responsibility trinity.” By following the “blueprint” provided by combining the “fiduciary responsibility trinity” with the “fiduciary prudence trinity,” ERISA attorneys and plan sponsors/plan fiduciaries can properly protect their respective interests.

Notes
1. In re Enron Corp. Securities, Derivatives, and “ERISA” Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003) (Enron).
2. Ibid.
3. Ibid.

© Copyright 2022 InvestSense, LLC. 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 “Fiduciary Responsibility Trinity”: ERISA Fiduciary Law After the Hughes/Northwestern Decision

Posted on February 25, 2022 by jwatkins

SCOTUS recently announced its much anticipated decision in the case of Hughes v. Northwestern University.1The significance of the decision cannot be overstated, as it dramatically changes the “rules of the game” for 401(k) and 403(b) retirement plans,

Hughes was the last piece of what I am referring to as the “Fiduciary Responsibility Trinity.” The Trinity is composed of three key ERISA related decisions-Tibble v. Edison International2, Brotherston v. Putnam Investments, LLC3, and Hughes. Given the heavy reliance that the Supreme Court and the First Circuit Court of Appeals, as well as the Solicitor General, placed on the common law of trusts, an argument can be made that the logic set out in the trinity decisions is equally applicable to all investment fiduciaries.

So why are the trinity so important? Here are key quotes from each decision.

Tibble:

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.4

The Restatement (Third) of Trusts is a restatement of the common law of trusts. So, the Court is recognizing the Restatement as a legitimate resource in addressing fiduciary questions.

Under trust law, a trustee has a continuing duty to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset…. Rather, the trustee must ‘systematic[ally] conside[r] all the investments of the trust at regular intervals’ to ensure that they are appropriate….In short, under trust law, a fiduciary normally has a continuing duty of some kind to monitor investments and
remove imprudent ones.5

Brotherson:

Congress sought to offer beneficiaries, not fiduciaries, more protection than they had at common law.6

[A]ny 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.”7

[T]he Restatement specifically identifies as an appropriate comparator for loss calculation purposes ‘return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).’8

In Brotherston, the lower court had ruled that the plan participants’ expert could not calculate alleged damages by comparing actively managed funds within the plan with comparable index funds, the court ruling that that would constitute comparing “apples to oranges.” The First Circuit’s decision effectively discredits the “apples to oranges” argument.

Hughes:

The Seventh Circuit erred in relying on the participants’ ultimate choice over their investments to excuse allegedly imprudent decisions by respondents. In Tibble, this Court explained that, even in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options…. If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty.9

The Seventh Circuit had dismissed the plan participants’ case on the basis of the “menu of options” argument, which said a mixture of both prudent and imprudent investment options within a plans was permissible, as it provided plan participants with more choices. SCOTUS effectively discredited the “menu of options” defense.

Going Forward
Bottom line, the combined impact of the trinity decisions is that cases will now be decided based on their merits, not on legal fictions such as the “apples and oranges” and “menu of options” defenses. This should result in more protection for plan participants in the form of fewer dismissals of 401(k)/403(b) …as long as the attorneys for plan participants properly plead such cases to meet SCOTUS’ plausibility standard for pleading.

Notes
1. Hughes v. Northwestern University, 19-1401 (2022).
2. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018).
4. Tibble, 1828.
5. Tibble, 1828-29.
6. Brotherston, 37
7. Brotherston, 39
8. Brotherston, 31
9. Hughes, Ibid.

Copyright InvestSense, LLC 2022. All rights reserved.

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

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