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

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

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

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

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

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

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

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


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

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


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

In our example, the actively managed fund assumed slightly less risk than the Vanguard index fund. As a result, the actively managed fund’s returned improved slightly, but not enough to avoid the same double loss suffered in the load-adjusted scenario. Once again, this double loss clearly makes the fund cost-inefficient and a poor investment choice.


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

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

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

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

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

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

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

2017 Year-End Top 10 DC Funds AMVR Analysis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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

Fiduciary Litigation 2018: A Pure Heart and an Empty Head Are No Defense

After my recent post, “Are We At A ‘Tipping Point’ in ERISA Fiduciary Litigation,” I received a number of calls and emails from legal colleagues and investment professionals who wanted to discuss the points I raised.  In the post, I suggested that in my opinion, we are at a tipping point due to several key facts.

First, as a result of SCOTUS’ decision in Tibble v. Edison Int’l, we now know that we can look to the Restatement (Third) Trusts (Restatement) for guidance and the applicable standards in fiduciary law, including ERISA related fiduciary matters.

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 duties, courts often must look to the law of trusts.

Second, my LinkedIn colleague, Gina Migliore, recently posted an article,”Hey Plan Sponsor, In Case You Did Not Know, You’re a Fiduciary,” addressing the fact that far too many plan sponsors still do not realize their fiduciary status or understand the legal obligations and liability exposure resulting from this designation.

These two facts lead me to believe that 2018 will not only see an increase in fiduciary related litigation, both ERISA and non-ERISA cases, but an increased in the success of such litigation. Plans and plan sponsors have celebrated recent wins in a few ERISA fee-based cases. However, I contend that those decisions are tenuous at best, at least with regard to the technical ERISA issues, due to what appears to be incorrect interpretations of cases such as Tibble and Hecker I and Hecker II. As a result, I would expect those key ERISA related decisions to be reversed, a sentiment recently expressed by leading ERISA plaintiff’s attorney, Jerome Schlichter.

In my opinion, the primary reason that ERISA fee actions are so successful is a misunderstanding among plan sponsors, plan advisers and financial advisers in general with regard to the evaluation and ongoing monitoring of investment fees. Whenever the issues of fees is raised in ERISA cases, plan sponsors and the investment immediately respond that ERISA does not require that they select the investment options with the lowest fees.

While this is true, is does not equate with an absolute immunity from recommending and selecting investment options that lack any inherent value for investors and pension plan participants. Taking Justice Breyer’s statement with regard to the value of the Restatement in interpreting fiduciary law as a starting point allows us to evaluate the viability of investment options using the clear and simple standards set out in the Restatement. Three standards in particular stand out, two setting out core fiduciary standard, and one setting out the fiduciary standard for actively managed mutual funds, a staple in most 401(k) plans and other types of pension plans.

With regard to a fiduciary’s core duties, Section 88 states that fiduciaries have a duty to be cost conscious. Section 90, comment f, states that fiduciaries have a duty to seek the highest return for a given level of risk and cost, or conversely, the lowest level of cost and risk for a given level of return. With regard to actively managed mutual funds, Section 90, comment h(2), of the Restatement notes that such investments often carry a higher level of costs and risks than comparable index funds. Therefore, the Restatement states that actively managed funds should only be included in a plan’s investment options when the expected return from such fund can reasonably be expected to provide a commensurate level of return o compensate for the additional costs and risk of the actively managed funds.

Simply put, the current menu of investment options within most 401(k) and other pension fail to meet any of these three hurdles. Not only fail to meet them, but fail miserably to meet such standards. As Carhart’s study showed, the returns of most actively managed funds fail to even cover their costs.(1) Our proprietary metric, the Active Management Value Ratio 2.0™ (AMVR), also shows that most actively managed mutual funds are not cost efficient, as their incremental costs exceed their incremental returns, as compared to an appropriate benchmark. As has been mentioned in several ERISA fees cases, losing a client’s money is never prudent.

The fact that many plan sponsors still do not recognize their fiduciary status and resulting fiduciary duties means that they are probably not aware of the standards established by the Restatement and the resulting liability exposure for failure to adhere to same. Ergo, increased litigation and more settlements and decisions in favor of plan participants.

The first time I meet with a prospective ERISA client, I ask them to tell me everything they know about ERISA law. The usual response is either along the lines of knowing that they have to comply with the rules to an immediate “deer in the headlights” stare. They often provide audit notes from a compliance advisor that list the usual 20-25 compliance requirement under the ’40 Act.

More often than not, the compliance adviser is not attorney and does not recognize the need to integrate both compliance and legal risk management standards into a plan to provide the plan with optimum legal protection. Far too often I see plans that offer 40-50 investment options, obviously operating under the mistaken belief that more is better, when in fact just the opposite is usually true. Offering a lot of funds that are highly correlated to each other and/or are cost inefficient, e.g., closet index funds, offers nothing for either the plan or the plan participants except liability exposure for the plan and the plan sponsor.

These very issues were discussed and resolved  in the Hecker decisions. In my experience, far too many compliance consultants and plan providers rely on Hecker I without reviewing Hecker II. As Fred Reish, one of America’s leading ERISA experts, admits, Hecker II effectively reversed Hecker I. As a result, many plan sponsors are left, as we say in the South, “nekkid in the wind,” totally defenseless to any ERISA fee litigation action.

CEOs and 401(k) plan sponsors often call me asking me how they can bulletproof their plan and avoid any liability. First the bad news. Since 401(k) fee cases address thing s that have occurred within the past six years, there is nothing a plan can do about liability arising from actions during that time. You can’t unring a rung bell.

The good news is that plans can implement and monitor an effective risk management program that provides the protection and benefits that both plan sponsors and plan participants want and need. Such risk management programs do not have to be cost prohibitive either. The key is to become and remain proactive in creating such as plan and monitoring the plan to ensure continued effectiveness.

One last factor to consider is the continuing efforts of the DOL, Congress and the Trump administration to block the full implementation of the DOL’s new fiduciary standard. In so doing, the DOL and Congress, as well as the SEC, underestimated the response from the states. Some states already impose a fiduciary duty on stockbrokers and other financial advisers. Nevada and other states have announced plans to protect their own citizens by exercising their police powers under the 10th Amendment to enact their own fiduciary standards. These state fiduciary laws will presumably include full discovery rights for investors, the one thing that the investment industry fears the most due to the possibility that it will expose even greater abuses by the industry. And there is nothing that Congress, the DOL, the SEC or the Trump administration can do to prevent the states from exercising their 10th Amendment rights and powers.

Increased fiduciary related litigation and more settlements and plaintiffs’ verdicts.  That’s my prediction and I’m sticking to it!

Selah

Notes
1. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.

Copyright © 2017 The Watkins Law Firm. All rights reserved.

This article 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, 403b, 404c, closet index funds, cost consciousness, DOL fiduciary rule, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans | Tagged , , , , , , , , , , , , , , , , , , , , , ,

There Are No Mulligans in Fiduciary Law

Webster’s dictionary defines a mulligan as “a free shot sometimes given a golfer in informal play when the previous shot was poorly played.” While various organizations are currently promoting various erroneous definitions of “fiduciary” and what a fiduciary’s duties include, as the Supreme Court noted in Tibble v. Edison International,(1) the courts usually look to the Restatement (Third) Trusts for guidance on fiduciary questions, especially in cases involving ERISA.

The issue of erroneous fiduciary definitions recently was spotlighted when Secretary of Labor Acosta testified before a Senate committee. In responding to a question posed by Congressman Robert Scott, D-Va., with regard to the department’s enforcement of their new fiduciary rules, Acosta responded by saying that

If companies are not proceeding in good faith [with the best interest standard], we still have enforcement authority. So if there are willful violations, we do have enforcement authority.

Huh? “Good faith” and “willful violations” as defenses, or perhaps more accurately loopholes, to breaches of one’s fiduciary duties. Mr. Secretary, as an attorney, you know, or should know, that the courts have consistently held that “a pure heart and an empty head” are no defense to allegations involving the breach of one’s fiduciary duties.(2) Any violation of one’s fiduciary duties, whether willful or not, are actionable, as a fiduciary ‘s duties are the highest known at law. A fiduciary liability for any mistakes is essentially absolute…no mulligans!

The courts and the regulators, as well as the Restatement, have consistently held that good faith alone is not a defense a breach of one’s fiduciary duties. Some examples include:

When a trustee “violates a duty because of a mistake as to the extent of his duties…he is not protected because he acts in good faith nor is he protected merely because he relies upon the advice of counsel.”(3)

ERISA’s reference to good faith is limited by the “overriding duties imposed by [ERISA Section] 404.(4)

“[A] fiduciary’s subjective good faith belief of his prudence will not insulate him from liability”(5)

“ERISA does not excuse a fiduciary’s breach of duty because the fiduciary acted in good faith.”(6)

“The fiduciary’s subjective good faith belief in an investment does not insulate him from charges that he acted imprudently.”(7)

A Test For Acosta and the DOL Truth-O-Meter
If we take Secretary Acosta at his word regarding pursuing enforcement for willful violations by companies not acting in good faith, then it will be interesting to see how, or if, the department will pursue the sale of variable annuities in connection with pension plans and plan participants. Variable annuities are annually among the top investments involved in customer complaints. Statistics show that the highest percentage of variable annuities sales are within pension plans and to plan participants.

There is a saying in the investment industry – annuities are sold, not bought. When one understands the high fees and associated costs associated with most annuities, especially variable annuities, and the impact of such fees and costs, the truth of the saying is clearly obvious. Since the cumulative fees and costs associated with variable annuities typically run in the 2-3 percent range, and each additional 1 percent in costs reduces an investor’s end return by approximately 17 percent over twenty years, a variable annuity investor could easily see over of their returns going to the variable annuity issuer in the form of fees and costs. So much for “retirement readiness” and “financial wellness.”

Moshe Milevsky’s study(8) of variable fees concluded that the fees charged by the average variable annuity, even in the best case scenarios, were 5-10 higher than the actual economic value of the benefit conveyed, thereby providing a windfall for the variable annuity issuer at the variable annuity owner’s expense. Fiduciary law is based primarily on the common law of equity. A basic axiom of equity law is that equity abhors a windfall. Therefore, the fact that most variable annuities produce a windfall for the issuer effectively negates any argument that recommendations of variable annuities to pension plans and plan participants cannot be said to be made in “good faith” and are therefore “willful” violations of one’s fiduciary duties. So, will we see enforcement actions initiated by Secretary Acosta and the department, or was this empty rhetoric by Secretary Acosta to placate Congress?

Simple, easily verifiable facts, especially by attorneys such as Secretary Acosta and the excellent attorneys there at the Department of Labor. Throw in the added fact that Secretary Acosta’s newly created loopholes, “good faith” and “willful” are inconsistent with long-standing fiduciary law, and the burden on Secretary Acosta and the department is to do their job and truly enforce the new fiduciary rule in order to carry out the department’s mission statement – to protect American workers and pension plan participants.

Notes
1. Tibble v. Edison International, 135 S. Ct. 1823, 1828 (2015)
2. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983)
3. Restatement (Second) of Trusts §201 cmt. a (1959)
4. Cunningham, 1467
5. Reich v. King, 867 F. Supp. 341, 343 (D. Md. 1994)
6. Martin v. Walton, 773 F. Supp. 1524 (S.D. Fla.1991)
7. Lanka v. O’Higgins, 810 F. Supp. 379, 387 (N.D.N.Y. 1992)
8. Moshe Milevsky, “Confessions of a VA Critic,” Research Magazine, January 2007, 42-48

© Copyright 2017 The Watkins Law Firm. All rights reserved.

This article 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 Annuities, BICE, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, pension plans, retirement plans | Tagged , , , , , , , , ,

Are We At a “Tipping Point” in ERISA Fiduciary Litigation?

As I went through my daily social media review, I noticed a post indicating that DOL Secretary Acosta has indicated that the DOL is ready to enforce the department’s new fiduciary rule (“Rule”). Excuse me if I’m skeptical, given the Secretary’s seeming opposition to the rule before he was even confirmed as Secretary.

Or perhaps Nevada’s announced intention to adopt its own state fiduciary law, as well as other states’ interest in doing the same, has caused Acosta to make his announcement, since state laws would ensure access to the courts for pension plan participants, making the Rule and accompanying best interests contract exemption, known as BICE, potentially irrelevant.

The Rule and BICE have the potential to address the ongoing abusive practices that drove the adoption of the Rule in the first place. However, the ongoing efforts of the DOL and Congress have raised serious questions as to whether the Rule and BICE will ever be totally effective. Hopefully, the states will follow through and adopt state fiduciary laws to ensure that investors, both retail and pension plan participants, are properly protected against the abusive marketing practices by the investment industry.

A number of recent decisions dismissing 401(k) actions involving fees and breach of fiduciary duties has caused some commentators and investment industry leaders to claim that the tide has shifted and such actions will meet with similar summary dismissals going forward. However, a closer analysis of the decisions suggests that such dismissals may result in nothing more than a false sense of optimism.

In reviewing the recent dismissals, the court’s rationale in dismissing the action typically involve three themes: the number of funds offered by a plan; the fact that a plan’s fees have been “approved” in other 401(k) actions, and/or alleged deficiencies in the plaintiff plan participants’ pleadings. With all due respect, the courts’ use of such issues appear to be inconsistent with prior court decisions and the primary resource used by the courts in fiduciary cases, especially actions involving ERISA issues. Pleading issues can always be addressed and prevented.

Dismissals Based on Number of Investment Options
Courts dismissing 401(k) actions involving fee and/or fiduciary breach issues based upon a plan’s number of investment options have frequently cited the decision in Hecker v. Deere(1) as justification for their decision. In that decision, the court appeared to suggest that the mere number of funds offered by a plan could ensure that the plan was insulated from liability for alleged breach of fiduciary duties.

However, the courts seemingly have ignored the fact that the 7th Circuit Court of Appeals subsequently went back and “clarified” their early decision in what is often referred to as Hecker v. Deere II(2). Most legal experts agree that the court’s “clarification” was actually a reversal of their earlier decision. Responding to concerns from the DOL and others that the court’s first decision was contrary to law and denied plan participants with basic  protections guaranteed under ERISA, the 7th Circuit sated that their earlier decision did not, and was not intended to, insulate plan sponsors and other plan fiduciaries, saying

The Secretary also fears that our opinion could be read as a sweeping statement that any Plan fiduciary can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such ‘‘obvious, even reckless, imprudence in the selection of investments’’ (as the Secretary puts it in her brief).(3)

So any decision dismissing a 401(k) fees/breach of fiduciary duties based on the number of investment option within a plan, with no consideration of the prudence of same, would be improper.

Dismissals Based on Investment Fees Being Within an Allowable Range
There is nothing in ERISA mentioned any specific allowable range of fees. The whole “allowable range” of fees theory has been derived by the courts and the investment industry based on cases in which ranges of fees were deemed fair and appropriate.

An interesting aspect of this logic is that for years the investment industry consistently argued that evaluating actively managed funds based purely on fees rather than the value provided by such funds was unfair and inappropriate…and they were, and still are, absolutely correct. And yet, that appears to be exactly what the courts are now doing.

As the Supreme Court has noted,

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 of Trusts sets out the common law of trusts. The Restatement’s position is that fees for actively managed mutual funds should be evaluated relative to the incremental return that such incremental fees and costs provide. Noting the extra costs and risks typically associated with actively managed funds relative to comparable index funds, the Restatement states that

those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…(5)

This is a significant hurdle for any plan choosing to offer actively managed funds. Analyses such as Standard & Poor’s Indices Versus Active Management (SPIVA) consistently show that most actively managed funds fail to outperformed their relative indices. Academic studies by well-respected parties such as Carhart(6) and Edelson, Evans and Kadlec(7)  go even further, as their findings show that most actively managed funds do not even manage to cover their costs, resulting in a net loss for investors.

The courts’ reliance on the “allowable range” logic is clearly inappropriate and indefensible as it ignores the importance of the requisite inherent value of a fund in terms of the positive incremental return, if any, provided to an investor. A basic axiom of fiduciary law is that “wasting beneficiaries’ money is imprudent.”(8) Before dismissing a 401(k) fees/fiduciary breach action, courts should compare an actively managed fund’s incremental return to the fund’s incremental costs.

Dismissals Based on Pleading Insufficiencies
Many of the recent dismissals involving   401(k) fees/fiduciary breach actions cited pleading insufficiencies such as failure to properly plead wrongful conduct and/or damages. The courts have every right to demand proper pleading from plaintiffs’ attorneys. Fortunately, such errors are easily corrected. Properly pleaded complaints should survive any motion to dismiss filed by the defendants.

Going Forward-Are We At a “Tipping Point” in ERISA Fiduciary Litigation?
In my humble opinion, the answer is “yes.” The rationale behind m opinion is that the courts will have little “wiggle room” to dismiss a 401(k) fees/fiduciary breach action if the action is properly plead and proper negation of the number of funds or “allowable range” of fees arguments in connection with any motion to dismiss.

Given the legal system’s reliance on the Restatement of Trust, investment fiduciaries, including plan sponsors, should know and understand the Restatement’s position on various fiduciary issues, especially Section 90 of the Restatement, more commonly known as “The Prudent Investor Rule.”

I continue to be amazed at how many investment fiduciaries have never looked at the Restatement. The usual response is that they will simply plead lack of knowledge and innocent mistake. For fiduciaries adopting such a strategy, expect to hear one or both of the following fundamental legal axioms – “ignorance of the law is no excuse” and “ a pure heart and an empty head are no defense in actions involving alleged breaches of one’s fiduciary duties.”

I expect to see more 401(k) fees/fiduciary breach actions focusing on the forgotten fiduciary duty, a fiduciary’s duty to be cost-conscious.(8) Restatement Section 88. Based on the SPIVA reports and my years of forensic analyses of actively managed mutual funds, very few actively managed mutual funds meet the Restatement’s requirement of cost-efficiency.

Using resources such as the Restatement and previously mentioned SPIVA reports, the academic studies of Carhart and Edelson, and InvestSense’s metric, the Active Management Value Ratio (AMVR™), plaintiff’s attorneys can easily establish the cost-efficiency of a plan, essentially bulletproofing their cases against successful dismissal actions. Elimination or a significant reduction in dismissal of 401(k) fees/fiduciary breach cases would clearly result in a “tipping point,” as pensions plans and investment fiduciaries would be forced to adopt prudent processes to ensure that they meet the applicable fiduciary standards or face the consequences.

Notes
1. Hecker v. Deere (Hecker I), 556 F.3d 575 (7th Cir. 2009)
2. Hecker v. Deere (Hecker II), 569 F.3d 708 (7th Cir. 2009)
3. Hecker II, at 711
4. Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015)
5. Restatement (Third) Trusts, Section 90 cmt h(2)
6. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
7. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/abstract=951367
8. Uniform Prudent Investor Act (UPIA), Section 7, comment

Copyright © 2017 The Watkins Law Firm. All rights reserved.

This article 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, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , ,

Unintended Consequences: Financial Advisers and Potential Liability Issues Under State Fiduciary Laws

With the investment industry driving and celebrating the continuous efforts of the DOL and Congress to emasculate the DOL’s fiduciary rule, I have received emails from stockbrokers and RIAs/IARs as to what the practical meaning of these actions, from a both a practice management and potential liability standpoint. I do believe that the actions of Congress and the DOL have important implications for the investment industry, including ERISA activity. I also believe that the industry may not be celebrating quite as loudly if some scenarios come true.

In my opinion, the development that could have the most impact on the investment industry is Nevada’s announcement that it will enact a state fiduciary law pursuant to its police powers under the 10th Amendment. A number of states already hold stockbrokers to a fiduciary standard as a result of state laws and/or state court decisions. RIAs and IARs are already held to a fiduciary standard under federal and state law.

Nevada’s announcement, and their announcement that other states had contacted them about following Nevada’s lead, caused quite a reaction in the investment world. Industry trade groups objected to such a move, claiming that ERISA was exclusively a federal issue and that Nevada’s passage of such a law would cause confusions. That argument has no merit, for as mentioned earlier, numerous states already hold stockbrokers and other financial advisers to a fiduciary standard. Furthermore, as long states approach any stockbroker and financial activity in the proper manner, there is nothing that the DOL, Congress, the administration or the courts can do to prevent any state from passing such state fiduciary laws, as it is within their 10th Amendment powers.

I have long been of the opinion that the real reason that the investment industry and other industry groups are so fervently concerned about the DOL rule is that it would protect an investor’s right to pursue legal recourse for violations in the courts, which in turn would provide investors with the right to full discovery. While an investor has a very limited right to discovery in arbitration, investors would enjoy a much broader right of discovery in the courts, discovery which result in the uncovering of other abusive practices by members of the investment industry and stronger cases by investors.

The current state fiduciary laws apply to any and all activity engaged in by stockbrokers and other financial advisers. As a result, current state fiduciary laws, as well as similar laws enacted by Nevada and other states going forward, could effectively replace a watered down or completely repealed BIC exemption since BICE, as currently proposed, applies to what is otherwise a simple securities situation, not an ERISA plan situation.

Waiver of Access to the Courts and Class Action Participation
As a plaintiff’s attorney myself, I have had already had several discussion with other plaintiff’s attorneys on potential issues resulting from the actions of the DOL and Congress, particularly the attack on the prohibition of forced binding arbitration provisions in BIC exemption agreements. The key issue in this regard would be whether any financial adviser who is subject to a fiduciary standard would violate their fiduciary duty of loyalty by advising, or forcing, an investor to forego an important and valuable legal right by waiving their right to pursue legal resource in the courts.

The securities arbitration process has long been the subject of criticism due to perceived manipulation of the process by the regulators and the investment industry. While things have improved somewhat, there is still the perception that investors would have a better opportunity for a fair and impartial trial in the courts. There is also the issue that recent evidence has shown that many stockbrokers and advisers who lose in arbitration never pay the winning investors the amounts awarded to them, with the regulators never doing anything to require such payments. Investors in court cases would have a number of legal options available to collect such financial awards.

The waiver of an investor’s right to redress in the courts would also have potential ERISA implications for plan sponsors, as they could be held liable for breach of their duty of loyalty by selecting a plan provider that required such a waiver, when other options were available that would not have required such waivers. As discussed earlier, such waivers are clearly not in the best interest of plan participants and investors.

Going Forward
Once I explain the practical implications of the situation, the next question inevitably involves some variation of “so what do I do?” My response is to continue to do what you have hopefully been doing all along. As mentioned earlier, RIAs and their representatives are already held to the “best interests” requirement of the fiduciary standard.

Broker-dealers and stockbrokers are always quick to claim that they are subject to the less stringent suitability standard, which does not require them to act in the best interests of a customer. I would suggest that recent regulatory releases and previous regulatory enforcement decisions suggest otherwise.

In interpreting FINRA’s suitability rule, numerous cases explicitly state that “a broker’s recommendations must be consistent with his customers’ best interests.” The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests…. The requirement that a broker’s recommendation must be consistent with the customer’s best interests does not obligate a broker to recommend the “least expensive” security or investment strategy (however “least expensive” may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer’s interests…. the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined. – FINRA Regulatory Notice 12-25 (emphasis added)

In interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s ‘best interests.’ – Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009)

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.Wendell D.Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154, at *11 (2003)

[A] broker’s recommendations must serve his client’s best interests. – Dep’t ofEnforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC Aug. 9, 2004)

In resolving the best interests question, I have always advised my consulting clients to follow the guidelines set out in the Restatement (Third) Trusts’ Prudent Investor Rule, especially the Restatement’s “forgotten” fiduciary duty, the duty of being cost conscious, as set out in Section 88 and Section 90, comment b. Stockbrokers and other financial advisers who recommend actively managed mutual funds to clients show pay particular attention to the fiduciary prudence standard set out in Section 90, comment h(2), which states that due to the additional costs and risks associated with actively managed funds as compared to index funds, actively managed funds should only be recommended if it is reasonable to assume that the gains from such actively managed funds will  compensate an investor for such additional costs and risks.

This is a significant hurdle for most actively managed funds, as studies such as Standard & Poor’s SPIVA reports and academic studies such as those done by Carhart(1) , Edelen, and Kadlec (2) have consistently found that most actively managed funds not only do not outperform comparable index funds, but that many actively managed mutual funds do not even manage to cover the fund’s costs. Underperforming funds and those that actually cost investors due to excessive costs clearly do not satisfy the “best interests” standard of either the common law fiduciary standard or FINRA’s suitability/best interest standard.

For stockbrokers and others who still do not believe they need to comply with a “best interests” standard in making recommendations, I would point to various courts’ rulings where they have agreed to impose a fiduciary duty on brokers advising accounts, even non-discretionary accounts, when justice and sense of fundamental fairness dictate same, with the admonition that

The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.  Follansbee v. Davis, Skaggs & Co., Inc., 681F.2d 673, 677 (9th Cir. 1982)

The issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s recommendations. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir 1975)

Conclusion
Gordon Gecko’s “greed is good” speech notwithstanding, the investment industry’s greed in trying to emasculate or completely repeal the DOL’s fiduciary rule has apparently resulted in a number of states proposing to join existing states with fiduciary laws in order to protect their citizens. Such fiduciary laws will govern all of a financial advisers actiities, not just ERISA related activity. Since no one can prevent the states from enacting  such legislation, prudent stockbroker and financial advisers will review the common law prudent/best interest investment standards as set out in the Restatement (Third) Trusts and adjust their business and due processes accordingly to avoid unnecessary liability exposure, whether in arbitration or in the courts.

Notes
1. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
2. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/ abstract=951367

© Copyright 2017 The Watkins Law Firm. All rights reserved.

This article 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 BICE, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, pension plans, prudence, retirement plans, RIA, RIA Compliance | Tagged , , , , , , , , , , , , , , , ,

Don’t Poke the Bear: Nevada Rains on Anti-Fiduciary Rule Parade

It is well established that ERISA comprehensively regulates employee pension and welfare plans, and t hat in the area of its coverage it preempts state laws and regulations. …However, it is also clear that there is a presumption against preemption, and that while ERISA’s preemptive effect is broad, it is not all-encompassing. As the Supreme Court has stated,”[s]ome state actions may affect employee benefit plans in too tenuous, remote, or peripheral a manner to warrant a finding that the law ‘relate to the plan….”
Duffy v. Cavalier, 215 Cal.App.3d 1517, 1527 (1989)

Most people are familiar with Gordon Gekko’s famous line from the movie “Wall Street”-“greed is good.” Right now, I’m guessing that the Department of Labor, Secretary Acosta, the investment industry and its trade groups are seriously questioning the accuracy of that statement.

Ever since Secretary Acosta assumed his position, he has made no secret of his pro-investment industry, anti-DOL’s new fiduciary rule position. The investment industry has made various requests in an effort to kill or seriously limit the impact of the rule. In each case, Acosta has granted their wishes, even thought the DOL was crested to protect the interests of American workers, not the investment industry. Secretary Acosta, the DOL, the investment industry and its trade groups have essentially thumbed their noses at American plan participants and retirees with indignation, sending the clear message that the DOL does not care about them.

However, there is another familiar saying–“be careful what you wish for.” In this case, you can only bully people for so long before they decide to fight back. The bullying efforts of the DOL and investment industry have now been countered by the state of Nevada’s announcement that the intend to exercise their 10th Amendment  police powers to protect their citizens by holding all stockbrokers and financial adviser in their state to a fiduciary standard.

Pandora’s box is officially open and the investment industry has clearly indicated its concern, and rightfully so. Other states have used legislation and/or court decisions to hold stockbrokers and financial advisers to a fiduciary standard for some time. Nevada’s announcement, and their statement that other states have already contacted them about following their lead, has implications far beyond just ERISA. States adopting a fiduciary standard for stockbrokers and financial advisers apply the standard to all activities of these parties, not just ERISA related activities. Greed is not good.

The investment industry’s response to Nevada’s annoouncement thus far has been a feeble allegation that Nevada’s adoption of a fiduciary standard for stockbrokers and financial advises will create confusion. What the investment industry and its trade groups realize is that that there is nothing they can do legally to prevent Nevada or any other state from creating and enforcing such laws under their 10th Amendment police powers. Likewise, there is nothing that the Trump administration, the DOL or Secretary Acosta can do to prevent Nevada from enacting such laws.

Equally troubling for the investment industry and other opponents of the DOL’s fiduciary standard is the fact that Nevada’s right to so act and the implications of such actions in ERISA cases has already been addressed in a well-reasoned decision, the aforementioned case of Duffy v. Cavalier. With regard to the DOL’s fiduciary rule. more specifically the DOL’s threats to essentially emasculate the Best Interest Contract exemption (BICE), Duffy stands for the proposition that states can enact laws to allow their citizens to protect their financial interests and preserve their access to the state’s court to do so.

Again, such fiduciary standards would apply to all activities of stockbrokers and financial advisers, not just ERISA related activity. Again, as long as states follow the guidelines set out in Duffy, there is absolutely nothing that the DOL, the investment industry or their trade groups can do to prevent any state from exercising its constitutionally protected 10th Amendment rights in enacting such fiduciary standards.

Nobody likes a bully. As they like to say here in the South, Secretary Acosta, the investment industry and its trade groups got greedy, “got too big for their britches,” and as a result, Nevada and other states decided that if the DOL was not going to do its job and protect plan participants and retirees, then they will use their police powers to do so. As a result, the investment industry has simply ensured that its members will face more stringent regulations and liability exposure in all of its activities, and there is nothing they can do to prevent same.

Check and checkmate.

P.S. For those wanting to read the Duffy decision, the decision can be accessed via www.leagle.com and searching the site using “Duffy v. Cavalier.”

Posted in 401k, 404c, 404c compliance, BICE, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, Fiduciary prudence, fiduciary standard, pension plans, prudence | Tagged , , , , , , , , , , ,