What If They Are Wrong?: How Court Decisions Impact 401(k) and 403(b) Plan Sponsors’ Fiduciary Risk Management Decisions

As an attorney and a fiduciary risk management consultant, my first thought when SCOTUS announced its decision in Hughes v. Northwestern University1 (Northwestern) was the renewed potential fiduciary risk liability for the plan sponsors. During the oral arguments, SCOTUS was able to get the plan’s own attorney to admit that the Seventh Circuits’ “menu of options” had no legal merit. So, it was a foregone conclusion that the plan would be found to have breached their fiduciary duties by offering both prudent and imprudent investment options within the plan.

Since then, I would argue that we have had a number of questionable decisions in both federal district and federal courts of appeal. In most of these cases, at least one point of contention has been the so-called “apples and oranges” argument.

The “apples and oranges” argument focuses on the use of index funds for benchmarking purposes in evaluating actively managed mutual funds. In one corner, we have the Brotherston2 decision, pointing to the Section 100, comment b of the Restatement (Third) of Trusts (Restatement), which clearly supports the use of index funds as comparators against comparable actively managed funds. Brotherston notes that in the Tibble3 decision, SCOTUS acknowledged that the courts often turn the Restatement for assistance in resolving fiduciary issues.

In the other corner, we have the courts who steadfastly ignore SCOTUS and Brotherson, arguing that actively managed funds can only be compared to similar actively managed funds. These courts argue that the different concepts, approaches, goals and strategies used by these types of funds preclude any meaningful comparison between active and index funds.

The Northwestern decision raises an interesting question. When SCOTUS vacates a decision of a lower court, in effect telling them “you made a mistake,” who pays for the lower court’s mistake? By that, I not only mean the party before SCOTUS, but other plans that may have relied on the lower court’s “mistake.” The lower court suffers no loss. They just take the case up again.

The same question applies to the plan provider who initially recommended the imprudent investments that the plan adviser ultimately chose for the plan. In many cases, the plan sponsor voluntarily agreed to give the plan adviser a fiduciary disclaimer clause, releasing the plan provider from any breach of fiduciary claims in connection with the advice it provided to the plan and its participants.

The importance of the fiduciary disclaimer clause preventing recourse by the plan against the plan adviser’s negligent or fraudulent actions cannot be overstated. As a result, I believe the grant of such a disclaimer should always be set out as a separate breach in any fiduciary breach action against the plan sponsor.

In many cases, the primary or sole reason a plan adviser was hired is because the plan lacked the knowledge and/or experience to independently select prudent investment options and otherwise manage the plan. In such cases, agreeing to a fiduciary disclaimer clause makes absolutely no sense.

So, a plan adviser arguably suffers no harm when SCOTUS or a federal court of appeals reverses a lower court’s adverse decision and reinstates the plan participants’ action. I say “arguably” because SCOTUS has upheld the right of plan sponsors to bring actions against plan providers on common law grounds such as negligence, fraud, and breach of contract.

Every time a court dismisses a 401(k)/403(b) action, the plan adviser industry celebrates on social media sites, often denouncing another “cookie cutter” case. I immediately look to the applicable law to determine if the court has ignored the standards set out in the Restatement and endorsed by SCOTUS. In most cases, I dismiss the erroneous decision and await the plaintiff’s decision as to whether they intend to appeal the decision.

One development we are seeing is more courts ignoring the “costs of discovery” argument as justification for dismissing otherwise meritorious 401(k)/403(b) actions. I have never understood that argument. simply because judges can properly address such concerns through “controlled” discovery, thereby avoiding the inequitable dismissal of an appropriate action. The Sixth Circuit recently provided an excellent analysis of this option in its TriHealth4 decision.

But at the pleading stage, it is too early to make these judgment calls. ‘In the absence of further development of the facts, we have no basis for crediting one set of reasonable inferences over the other. Because either assessment is plausible, the Rules of Civil Procedure entitle [the three employees] to pursue [their imprudence] claim (at least with respect to this theory) to the next stage….’ (citing Fabian, 628 F.3d at 281)

This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry….In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.

Going Forward
Increasingly, the decision dismissing meritorious 401(k)/403(b) actions eventually turns out to be nothing more than an act providing a plan with a temporary and false sense of security. Fortunately, there are simple risk management steps a plan sponsor can do in designing and maintaining a plan to reduce and/or eliminate a plan sponsor’s potential fiduciary liability exposure, including:

(1) Never agree to a plan advisory contract that contains a fiduciary disclaimer clause.
(2) Always require that a plan adviser provide the plan with an Active Management Value RatioTM (AMVR) forensic analysis for each product recommendation, using only the official AMVR format, as shown throughout this blog site.
(3) Consider having an independent and objective fiduciary risk management audit performed to ensure maximum protection against unnecessary fiduciary liability.
(4) Plan sponsors should learn how to personally prepare and evaluate an AMVR forensic analysis so that they can comply with ERISA’s requirement that a plan sponsor conduct a thorough, objective, and independent investigation and analysis of each investment option offered by a plan.

Fiduciary risk management need not be overly complicated or intimidating. The key is in properly designing a simple, cost-efficient and ERISA compliant fiduciary risk management system so that the plan sponsor can avoid the costs and hassles of litigation.

Notes
1. Hughes v. Northwestern University, 953 F.3d 980 (2020).
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018).
3. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
4. Forman v. TriHealth, Inc., 40 F.4th 433, 453 (6th Cir. 2022)

Copyright InvestSense, LLC 2022. All rights reserved.

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



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The Active Management Value Ratio™ Step-by-Step: Investment Analysis and Risk Management for Investment Fiduciaries

James W. Watkins, III, J.D., CFP Board EmeritusTM, AWMATM

Your 401(k) plan adviser recommends Fund XYZ and tells you the fund has a ten-year annualized return of 12.63 percent, beating the comparable Vanguard Large Cap Growth Index Fund. Ask him to provide you with an AMVR analysis, including risk-adjusted returns and correlation-adjusted costs.

There is currently a division with the federal courts that is effectively denying American employees a fair and equal interpretation and application of the rights and protections guaranteed to them under Employee Retirement Income Security Act (ERISA). The division within the courts is arguably resulting in some courts protecting Wall Street and employers rather than employees, in the courts committing essentially the same sort of abusive practices that ERISA was designed to prevent.

One of the key inconsistencies between the court is whether index mutual funds can be used in determining whether plan participants can use index mutual funds to determine whether a plan sponsor breached their fiduciary duties in selecting investment options for a plan, as well as in calculating the damages resulting from a breach.

In Tibble v. Edison International1, SCOTUS endorsed the Restatement of Trusts (Restatement) as a resource in resolving disputes involving fiduciary law. In Brotherston v, Putnam Investments, LLC2, the First Circuit addressed the Tibble endorsement and applicable portions of the Restatement.

The Restatement calls “for determining whether and in what amount the breach has caused a `loss’ . . . by reference to what the results `would have been if the portion of the trust affected by the breach had been properly administered.’”3 

Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes “return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).”4 (citing § 100 cmt. b(1)

ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for “any losses to the plan resulting from each such breach.” Certainly this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent “to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.”5 (cites omitted)

And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts. (citing Varity Corp. v. Howe, 516 U.S. 489, 496-97, 502, 506-07 (1996) (relying on “ordinary trust law principles” to fill gaps created by ERISA’s lack of definition regarding the scope of fiduciary conduct and duties).6

Despite the Restatement’s clear approval of index mutual funds for benchmarking purposes, some courts continue to reject the use of index funds for benchmarking purposes. Courts rejecting the use of index often allege that possible differences in investment goals, asset allocations, investment strategies, and other differences between index funds and similar actively managed mutual funds. such courts often argue that comparing index funds to actively managed is like comparing “apples and oranges.”

One could argue that such an argument is unnecessarily myopic, given the Restatement’s position and ERISA’s stated purpose and goal, the protection of employees and their pursuit of “retirement readiness.” In many cases, the active/passive dispute has seemingly overtaken the best interests and protection of employees as ERISA’s primary focus. This development is even more troubling when one could legitimately argue that cost-efficiency, or more properly cost-inefficiency, is the more meaningful standard to assessing fiduciary prudence and potential fiduciary breaches

Assessing Fiduciary Prudence
Several investment icons have helped define the proper elements of an analysis of fiduciary prudence. Nobel laureate William F, Share helped establish the general framework of analysis, stating that

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.7

Noted investment expert, Charles D. Ellis, then contributed important details, 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.8

Several years ago, I created a simple metric, the Active Management Value RatioTM (AMVR), based on those properties. The chart below presents a visual interpretation of the combination of the concepts of Sharpe and Ellis.

The basic AMVR is simply the cost/benefit analysis many of us learned in our Econ 101 class, with the inputs being incremental costs and incremental returns. In analyzing an AMVR analysis, the user only needs to answer two simple questions:

(1) Did the actively managed fund provide a positive incremental return?
(2) If so, did actively managed fund’s positive incremental return exceed the fund’s incremental costs.

If the answer to either of these questions is “no,” then, under the Restatement’s standards, the actively managed fund is imprudent relative to the benchmark index fund.

In this case, the actively managed fund actually had a ten-year annualized nominal return of 11.90 and underperformed the comparable index fund. As a result, the active fund would be cost-inefficient relative to the comparable index fund.

But there is a more fundamental issue with comparing the performance of an actively managed fund against an index fund based upon nominal returns alone. Nominal returns are the returns that investors can find online at sites such as Morningstar, Market Watch and Yahoo! Finance and in newspapers. In order to provide the “apples to apples” analysis some courts continue to cite as a key element in their decision to dismiss an action, other important investment factors need to be considered as well.

Risk-Adjusted Returns
A common investment saying is that returns are a function of risk. The Restatement acknowledges this concept, stating that the use of investment strategies incorporating active management are imprudent unless it can be objectively predicted that they will provide an investor with a commensurate return for the extra costs and risk assumed.

Risk-adjusted returns adjust the nominal returns of an investment to factor in the risk assumed by an investor in such investment. Investors who assume greater risk should reasonably expect a commensurate return.

The chart below shows the result of factoring in risk for each of the two investments.

Actively managed funds are naturally expected to have higher costs and risk than index funds due to the very nature of active management. In this case, the index fund actually had the higher standard deviation in returns. As a result, factoring in risk actually improved the active fund’s performance (reduction by 100 bps) relative to the index fund’s risk-adjusted performance (reduction by 158 basis points).

Basis points are typically used in the financial services industry. A basis point equals 1/100 of 1 percent. For simplicity, I often suggest that those uncomfortable with basis point just monetize the number, e.g., 100 basis points equals $1.00, 150 basis points equal $1.50).

So, the actively managed fund did have a higher annualized risk-adjusted return than the comparable index fund, by 8 basis points. However, the actively managed fund would still remain cost-inefficient, as the active fund’s incremental costs (69 basis points) significantly exceeded the fund’s modest incremental return (8 basis points). As a result, an investor would still suffer a loss by investing in the3 active fund relative to the active fund.

The key is just to compare the actual risk-adjusted returns to the active fund’s incremental costs to determine which fund had the more cost-efficient performance once incremental costs are factored in. Most financial advisers and courts look only at returns without factoring incremental costs

Correlation of Returns and “Closet Indexing”
The next step is to determine if the actively managed fund in our AMVR analysis provides a commensurate return relative to the active fund’s incremental costs. The analysis indicates that the active fund charges an incremental cost of 69 basis points; yet provides no benefit to an investor in the actively managed fund that to offset such incremental costs.

While that scenario is troubling enough, does it actually indicate the full extent of the active fund’s cost impact relative to the index fund? The risk-adjusted AMVR chart shows that an investor essentially gets a similar return for just 5 basis points and avoid the incremental cost of 69 basis point. As John Bogle explained, an investor gets to keep what they do not pay for, in this case an additional 69 basis points in the return.

But does that simple calculation accurately express the full extent of the impact of the actively managed fund with regard to the fiduciary prudence of the active fund? Ross Miller’s Active Expense Ratio (AER) suggests that the cost-inefficiency of many actively managed funds may be even worse than appears at first glance.

Miller’s research suggests that the effective expense ratio of many actively managed funds is often understated by as much as 300-400 percent, sometimes even more. Miller explained the importance of the Active Expense Ratio and Active Weight (AW) metrics as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.9

In our example, the correlation of returns between the two funds was 97. Some would suggest that that number indicates an investor in the active fund is only getting two percent of active management. Miller’s Active Weight metric found that in calculating the percentage of active management provided by an active fund, the relationship between correlation of returns and active management is not one-to-one.

The AER calculates an active fund’s AW using only the fund’s correlation of returns and incremental costs numbers. The higher the active fund’s correlation number and incremental costs, the higher the active fund’s AER, which negatively impacts the active fund’s AMVR score and overall cost-efficiency. In this case the active fund’s high correlation number (97) combine with the relatively high incremental costs (69 basis points), resulted in an effective expense ratio of 5.52, or almost 700 percent higher than the fund’s stated expense ratio.

The majority of U.S domestic equity funds currently have correlation number of 90 or above, with many having numbers of 95 and above. As a result, factoring in correlation of return number is arguably more important than ever in order to avoid fiduciary liability.

Funds that have correlation numbers of 90 and above are often characterized as “closet index” funds. Closet indexing is often described as actively managed funds promoting the benefits of active management and charging higher management fees, while actually tracking the performance of comparable index funds, but underperforming such index funds due to the higher fees and other costs of the active fund.

Going Forward – Changing the 401(k)/403(b) Litigation Paradigm
I provide forensic fiduciary prudence analyses for pension plans, trusts, trial attorneys and investors. Just like many studies, my AMVR analyses have concluded that the overwhelming majority of actively managed funds are cost-inefficient when compared to comparable index funds. While there are those that argue that actively managed funds can only be compared to other comparable actively managed funds, that argument has no legal foundation, is contrary to the Restatement, and inconsistent with the stated purpose of ERISA, protection and promotion of employees’ financial well-being.

The AMVR process is both simple and consistent with the Restatement’s position on the prudence of using active management strategies, normalizing both the costs and risks factors in order to allow for the “apples to apples” comparison that so many court reference in prematurely dismissing many 401(k)/403(b) actions. The closet indexing issue makes such premature dismissals just that much more draconian and inequitable.

Some courts have dismissed 401(k)/403(b) actions citing “modest” or “insignificant” incremental costs and/or losses. The GAO has noted that over a 20-year period, each additional one percent in costs/fees reduces an investor’s end-return by 17 percent.10 Underperformance qualifies as an opportunity cost, thus justifying its inclusion in the SEC’s and GAO’s equation.

Yet, I have never seen any court acknowledge the GAO’s report or factor in this impact of such “modest” fees before a dismissal based on such grounds. Most courts simply look at a fund’s nominal returns, which, as has been shown herein, can often be misleading.

Plaintiffs absolutely have a legal obligation to properly plead their cases so as to meet the plausibility requirement. I believe that plaintiff’s attorneys can meet that standard using the AMVR, especially when risk-adjusted returns and correlation-adjusted costs considered.

One trend that has been noted by legal critics is the courts’ tendency to confuse the plausibility pleading requirement and the proof of causation issue. The two requirements are totally separate and distinct and should be treated as such, especially since at the pleading stage, plaintiffs have not had the opportunity to conduct of discovery to learn what processes the plan sponsor and whether the complied with the other ERISA requirements.

Asking the plan participants to prove causation when the requisite information and evidence is known on to the plan is clearly inequitable. That said, in a worst-case scenario, I would argue that the data provided by the AMVR often provides strong circumstantial evidence that the plan sponsor either did not perform, or ignored, the required independent and objective analysis of all of the plan’s investment options. As John Adams said, “facts do not cease to exist because they are ignored.”

Some courts have attempted to justify their combination of the pleading and proof stages by citing the need to avoid the costs of discovery. As some courts have pointed out, that argument is disingenuous, as judges can allow “controlled” discovery, effectively avoiding unnecessary and unneeded discovery costs.

SCOTUS had the opportunity to resolve both the “apples and oranges” and burden of proof on causation issues earlier in the Brotherston action, when Putnam Investments asked SCOTUS to review the First Circuit’s decision. The Solicitor General supported the First Circuit’s decisions rejecting the “apples and oranges” argument and placing the burden of proof as to causation on plan sponsors. However, SCOTUS eventually refused to hear the appeal due largely to the fact that the appeal was an interlocutory appeal, meaning the case was still in progress. The case eventually settled.

SCOTUS needs to decide these issues as soon possible in order to ensure uniformity by the federal courts in interpreting and applying ERISA and to minimize the damages caused by these inconsistencies. The rights and protections guaranteed to employees under ERISA are simply too important to employees’ goals of “retirement readiness” and “financial wellness” to depend on the judicial jurisdiction of an employee’s legal residence. The Active Management Value Ratio provides a simple method for SCOTUS and any other court to perform an objective and equitable comparison of an actively managed fund and a comparable index fund, based on a truly meaningful standard, cost-efficiency.

Notes
1. Tibble v. Edison International, 135 S. Ct 1823 (2015).
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
3. Brotherston, 31
4. Brotherston, 31.
5. Brotherston, 31.
6. Brotherston, 33.
7. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
8.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.
9. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
10. GAO-08-95T, “Private Pensions: 401(k) Plan Participants and Sponsors Need Better Information,” https://www.gao.gov/assets/gao-08-95t.pdf

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, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, closet index funds, clsoet 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, fiduciary risk management, fiduciary standard, investment advisers, investments, pension plans, plan advisers, plan sponsors, prudence, retirement planning, retirement plans, risk management, SCOTUS, Supreme Court, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , | Leave a comment

Who Will Tell the Plan Sponsors?: The Truth About the Looming Fiduciary Liability Trap in 401(k) and 403(b) Litigation

I have been reading a number of articles from some very impressive law firms suggesting that the attorneys for 401(k)/403(b) firms should file combine motions to dismiss with motions for summary judgment in order to deny plan participants from obtaining discovery. Fortunately, I believe most judges understand that such a move would simply ensure that SCOTUS would review the case and address the current state of 401(k)/403(b) litigation.

I have written two previous posts about the courts improperly confusing the plan participants’ duty to plausibly plead the elements of their case with a duty of one of the parties to prove what caused alleged losses. Plan participants can plausibly plead their breach of fiduciary duty claims by showing that a plan sponsor breached their fiduciary duties and the resulting losses. That is easily accomplished by using my simple Active Management Value Ratio (AMVR) metric, which allows attorneys, investment fiduciaries and investors to determine the cost-efficiency, i.e., prudence, of an actively managed fund relative to a comparable index fund.

The first forensic AMVR analysis compares the K shares of the well-known Fidelity Contrafund Fund (FCNKX) with the popular Fidelity Large Cap Growth Index Funds (FPSGX). As the analysis shows, not only does FCNKX underperform FSPGX by 237 basis points, but a plan participant would incur an even greater loss by having to pay an incremental fee of 70 basis points. Add the two losses together and, assuming similar annual results, a plan participant choosing FCNKX would suffer an annual loss of over 300 basis points.

Per the General Accounting Office (GAO), each additional one percent in costs and fees reduces an investors end-return by approximately seventeen over a twenty-year period. So, by choosing FCNKX instead of FSPGX, the plan sponsor essentially ensures that a participant in the plan may lose over half of their end return from FSPGX.

So, the obvious question is why would a prudent plan sponsor choose FCNKX over FSPGX as an investment option in their plan. One plan sponsor quickly pointed out that she chose FCNKX over FSPGX because Fidelity does not offer FSPGX to 401(k)/401(b) plans. As I explained to her, that still would not justify the choice of a cost-efficient and imprudent investment option.

So, how would FCNKX match up with the Admiral shares of Vanguard’s version of a Large Cap Growth Index Fund (VIGAX)? As the chart shows, FCNKX would still be an imprudent choice for a fiduciary, underperforming VIGAX by 96 basis points and forcing an investor to incur an incremental loss of 69 basis points, for a combined loss of 165 annually and Better, but still imprudent and a breach of the plan sponsor’s fiduciary duties.

American Funds’ Growth Fund of America (GFOA) is another investment option in 401(k)/403(b). Comparing the R-6 shares of GFOA (RGAGX) with VIGAX produce similar result to the FCNKX results.

Plan participants investing in RGAGX would suffer an opportunity loss of 210 basis points and 25 basis points in incremental costs, for total damages of 245 basis points annually. Using GAO’s formula, that means that a plan participant would suffer approximately a 41 loss in end-return over 20 years.

So, plan participants’ attorneys using the AMVR metric should have no problem satisfying the federal plausible pleading requirement. Having done so, plan participants should be allowed to proceed with full discovery in the action.

Who’s Responsible for Proving Causation of Damages
Once the plan participants have shown both a fiduciary breach and the resulting losses, the next question is who is responsible for causing such damages. Ah, there’s the rub.

ERISA itself does not expressly state who is responsible for proving causing the losses incurred. So naturally, we have a split between the federal Courts of Appeal on the issues.

Both the First Circuit Court of Appeals and the Solicitor Genral addressed this issue in connection with the Brotherston case. As mentioned earlier, I have written two posts addressing the proof of causation conundrum – “Brotherston v. CommonSpirit Health: An Opportunity, and a Need, to Shift the 401(k) Litigation Paradigm,” and “Game Changer-Why Hughes v. Northwestern University Matters.”

As both the First Circuit and the Solicitor General have pointed out, a number of the federal courts have exacerbated the problem by deliberately and improperly trying to force plan participants to prove causation in connection with motion to dismiss proceedings. In essence, by denying plan participants any discovery whatsoever, some courts are forcing the plan participants to speculate as to why the plan sponsor chose obviously imprudent investments and thereby breached their fiducairy duties, as that information is known only by the plan sponsor.

First, from the First Circuit and Judge Kayatta:

The Restatement calls “for determining whether and in what amount the breach has caused a `loss’ . . . by reference to what the results `would have been if the portion of the trust affected by the breach had been properly administered.’”1 

Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes “return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).”2 (citing § 100 cmt. b(1)

ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for “any losses to the plan resulting from each such breach.” Certainly this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent “to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.”3 (cjtes omitted)

And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts. (citing Varity Corp. v. Howe, 516 U.S. 489, 496-97, 502, 506-07 (1996) (relying on “ordinary trust law principles” to fill gaps created by ERISA’s lack of definition regarding the scope of fiduciary conduct and duties).4

[T]he burden of showing that a loss would have occurred even had the fiduciary acted prudently falls on the imprudent fiduciary. By allowing its analysis on loss to be driven by its concern regarding the objective prudence of the Putnam funds, the district court in essence required plaintiffs to show causation as part of its case on loss-even as it correctly sought to reserve that requirement to defendants.5

So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes).6

As to the responsibility for proving causation, Judge Kayatta stated that

[T]here is what the Supreme Court has called the “ordinary default rule.” Under this rule, courts ordinarily presume that the burden rests on plaintiffs “regarding the essential aspects of their claims.” That normal rule, however, “admits of exceptions….” For example, “[t]he ordinary rule, based on considerations of fairness, does not place the burden upon a litigant of establishing facts peculiarly within the knowledge of his adversary,” although there exist qualifications on the application of this exception.7

That exception recognizes that the burden may be allocated to the defendant when he possesses more knowledge relevant to the element at issue…. Common sense strongly supports this conclusion in the modern economy within which ERISA was enacted. An ERISA fiduciary often — as in this case — has available many options from which to build a portfolio of investments available to beneficiaries. In such circumstances, it makes little sense to have the plaintiff hazard a guess as to what the fiduciary would have done had it not breached its duty in selecting investment vehicles, only to be told “guess again.” It makes much more sense for the fiduciary to say what it claims it would have done and for the plaintiff to then respond to that.8

In concluding, Judge Kayatta made two significant points:

The Supreme Court has time and again adopted ordinary trust law principles to construe ERISA in the absence of explicit textual direction.9

[T]he Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits…. In other words, Congress sought to offer beneficiaries, not fiduciaries, more protection than they had at common law, albeit while still paying heed to the counterproductive effects of complexity and litigation risk.10

Next, from the Solicitor General as to the issue of pleading plausibility:

Considering those allegations together and taking them as true at the pleading stage, the Amended Complaint plausibly states a claim that respondents acted imprudently….11

Petitioners did not merely present a conclusory assertion that the Plans’ recordkeeping fees were too high; they substantiated their claim with specific factual allegations about market conditions, prevailing practices, and strategies used by fiduciaries of comparable Section 403(b) plans.12

Going Forward
Full disclosure: I am, by nature, a plaintiff’s attorney. I fully support the federal rules requiring that plaintiffs establish the plausibility of their actions. I fully acknowledge that ERISA does not expressly provide that plan sponsors have the burden of proof with regards to causation of damages. However

However, I do agree with Judge Kayatta that since only plan sponsors know whether they fulfilled their fiduciary duties by conducting an independent investigation and evaluation of each investment option selected for a plan, as well as the methodology they employed in connection with such duties, it would make sense to shift the burden of proof on causation to the plan sponsor.

If a court is determined to force the plan participants to carry the burden of proof regarding causation, it is clearly inequitable and arguably a blatant violation of the spirit and purpose of ERISA to deny plan participants the opportunity to conduct meaningful discovery to determine whether a plan sponsor did in fact breach their fiduciary duties by not properly conducting their independent investigation and evaluation of the plan’s investment options, or not performing such duties at all. In many cases, the results of an AMVR analysis on each investment option in the plan results in strong circumstantial suggestions of the latter being true

One could argue, with merit, that by confusing the burden of proof with the duty of plausible pleading and denying plan participants the rights and protections provided for them under ERISA, some courts are guilty of the very same sort of abusive actions that ERISA was created to protect employees against. In this case, the only difference is that the legal system is the offending party.

But judges are smart people; they have to understand that the duty to plead plausibly and the burden of proof are properly two separate duties which, while related, are legally understood to be two distinct proceedings, primarily to allow the party carrying the burden of proof to gather the necessary information and evidence. So why are some courts seemingly determined to blatantly deny plan participants their ERISA rights and protections in order to protect plan sponsors who breach their fiduciary duties? My guess they will never allow us to discover the answer to that question.

In the meantime, I am advising my clients to ignore all the celebratory announcements, articles, and posts when a court dismisses a 401(k) or 403(b) action. Why? When SCOTUS eventually addressed these issues, just as in the Northwestern University case, and SCOTUS vacated the Seventh Circuit’s decision, it was neither the plan adviser, who provided the improper advice, nor the Seventh Circuit, who misinterpreted the plain language of ERISA, who faced renewed liability and damages. It was only the plan sponsor, Northwestern University, the faced the renewed liability exposure.

I try to read every decision handed down in connection with 401(k)/403(b) actions to determine whether the decisions are based on solid legal reasoning and consistent with applicable laws or regulations. As I tell my fiduciary clients, without those two foundations, a decision in favor of a plan sponsor often accomplishes nothing more than create a temporary and false sense of security, while the plan participants decide whether to appeal.

One final point. Thus far, the recent decisions dismissing 401(k)/403(b) actions have ignored both the First Circuit’s decision and the court’s reasoning and excellent analysis of the applicability of the common law of trusts and the Restatement (Third) of Trusts (Restatement). The decisions have ignored SCOTUS’ recognition of the Restatement as a resource in settling fiduciary disputes. More specifically, the decisions have ignored the commonsense standards of fiduciary prudence set forth in the Section 90 of the Restatement, otherwise known as the “Prudent Investor Rule,” such as comments b, f, and h(2).

SCOTUS had an opportunity to address these issues earlier when Putnam Investments asked the Court to review the case. It was the perfect case to resolve these issues. However, SCOTUS followed the Solicitor General’s advice and refused to hear the appeal, as the appeal was what is known as an interlocutory appeal, meaning the case was still in progress in the First Circuit Court of Appeals. The case eventually settled.

As the Solicitor has noted several times, ERISA is simply too important to not have the courts apply the law consistently and equitably. It has been estimated that approximately 30 percent of the nation’s wealth in tied up in 401(k) and 403(b) plans. The potential economic harm to both plan participants and plan sponsors from the current inconsistent and inequitable trends in 401(k)/403(b) litigation are just too important to continue to be unaddressed and unresolved.

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 31 (2018) (Brotherston).
2. Brotherston, 31.
3. Brotherston, 31.
4. Brotherston, 31.
5. Brotherston, 33.
6. Brotherston, 34.
7. Brotherston, 36.
8. Brotherston, 36.
9. Brotherston, 37
10. Brotherston, 31.
11. Brief for the United States as Amicus Curiae, Hughes v. Northwestern University, United States Supreme Court, No. 19-1401, 14. (Amicus Brief)
12. Amicus Brief, 14.

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

Target Date Funds Have Now Become the Targets of 401(k) Litigation (Part 2)

In my last post, I analyzed the popular Fidelity Freedom Active Suite and Fidelity Freedom Index target date funds. The Fidelity Freedom and TIAA-CREF Lifestyle target date funds are arguably the two most popular groups of target date funds in 401(k) and 403(b) defined contribution plans.

However, popularity does not necessarily equate to fiduciary and regulatory prudence. Many mutual funds are cost-inefficient when compared to comparable index funds. Many fiduciaries and investors alike choose mutual funds based on their publicly advertised, aka nominal, returns.

Nobel laureate Dr. William Sharpe has stated that

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

Noted wealth management expert, Ellis, goes further, stating that

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

Ellis’ suggestion is a variation of the cost-benefit analysis commonly used by businesses every day. Several years ago, I created a simple metric based on Ellis’ studies, the Active Management Value Ratio (AMVR). The AMVR allows fiduciaries, attorneys, and investors to quickly assess the cost-efficiency of an actively managed mutual relative to a comparable index fund.

Most index funds have higher fees and expenses than comparable actively managed funds. Those higher fees and expenses effectively reduce an actively managed fund’s performance. As a result, studies have consistently shown that most actively managed mutual funds are cost-inefficient when compared to comparable index funds.

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.3
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.4
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.5
  • [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.6

Such is the case when TIAA-CREF’s active and index target date funds are compared over the most recent ten-year and five-year periods.

In analyzing the TIAA-CREF Lifestyle TDFs over the most recent five and 10-year periods (ending September 30, 2022) all of the funds proved to be cost-inefficient, i.e., incremental costs greater than incremental returns, relative to their comparable index version. As a result, it can be said that the actively managed TIAA-CREF Lifestyle funds would be an imprudent investment choice relative to the indexed version of the same funds.

Going Forward
401(k) and 403(b) plan sponsors are legally fiduciaries. As such, they are held to “the highest duties known to law,” including the duties of prudence and undivided loyalty to the plan participants and their beneficiaries. Bottom line, a plan sponsor’s selection of cost-inefficient investment options for a plan is an unquestioned violation of their fiduciary duties.

A common risk management mistake I see made by plan spsonsors is agreeing to a plan advisory contract that contains a so-called “fiduciary disclaimer clause.” I have argued that agreeing to such a clause is a violation of both the plan sponsor’s fiduciary duties of prudence and loyalty.

Without a fiduciary disclaimer clause, a plan adviser would be subject to the same fiduciary duties that a plan sponsor is required to honor. I maintain that that would force a plan provider to offer all investments that their broker-dealer sells, not just the overpriced and consistently underperforming products of their so-called “preferred partners.”

Plan sponsors often agree to such fiduciary disclaimer clauses in exchange for revenue sharing payments from the broker’s/adviser’s broker-dealer. The plan sponsor then uses such revenue sharing payments to reduce the plan’s administration costs.

The legal issue with such fiduciary disclaimer clause/revenue sharing arrangements is that reducing administrative costs does not change the cost-inefficiency of imprudent investment options within the plan or otherwise reduce the ongoing financial impact of such imprudent investments. As the TIAA-CREF charts herein show, those costs and expenses can add up quickly and compound over time. Each additional one percent in costs and expenses reduces an investor’s end return by approximately seventeen percent over a period of twenty years.

My fiduciary consulting clients are very familiar fiduciary risk management sayings – “Why even go there” and “Don’t even go there.” Far too many plan sponsors fail to follow such advice and expose themselves to unnecessary and unwanted fiduciary liability.

Notes
1. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
2. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
3. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
4. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
5. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
6. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997). 24.

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

Target Date Funds Are Now the Targets

In my last post, I published the “cheat sheets” for six of the most commonly used non-index-based funds in U.S. defined contribution plans. However, those funds did not include any target date funds (TDFs).

TDFs are diversified asset allocation funds which supposedly provide a simple way for investors to work toward “retirement readiness” and “financial well-being.” However, questions have started to arrive as to the prudence of TDFs in terms of both safety and cost-efficiency. As a result. TDFs have become the targets themselves of 401(k) and 403(b) litigation.

Two of the largest litigation targets have been Fidelity’s Freedom TDFs and TIAA-CREF’s Lifecycle TDFs. One of the primary issues in litigation involving these two groups of TDFs has been the fact that both offer both active and passive versions of their TDFs.

In both cases, the active versions of the TDFs charge higher fees. Most 401(k) and 403(b) plans have chosen the active versions of the TDFs, despite their consistent underperformance over time relative to the less expensive passive, or index, versions of the funds.

Several courts have dismissed 401(k) and 403(b) cases citing the alleged failure of the plan participants to properly plead their cases. Under the federal rules of civil procedure, the plan participants are required to provide sufficient facts to show that it is plausible to believe that the plan’s sponsor failed to properly perform their fiduciary duties of loyalty and/or prudence.

Some courts have accepted evidence of the disparity between a fund’s costs and returns as providing sufficient evidence of the plausibility that a plan sponsors failed to properly perform their fiduciary duties. One such case is the Leber v. Citigroup 401(k) action1, where highly respected Judge Sidney Stein denied Citigroup’s motion to dismiss the case, citing the fact that the plan participants had shown that in some cases the expense ratios of the funds in question were 200 percent of more higher than the expense ratios of comparable Vanguard funds.

Judge Stein’s recognition of both the impact of a disparity in expense ratios and the legitimacy of Vanguard funds as comparators in 401(k) and 403(b) cases should not go unnoticed. Nevertheless, some courts continue to ignore and/or reject similar evidence as establishing the plausibility of a fiduciary breach, as required in 401(k) and 403(b) cases.

In my practice, I also calculate a “plausibility factor” based upon my Active Management Value Ratio (AMVR) analyses. In the case of the two charts shown above, the plausibility should be resolved for the five-year period by the fact that with the exception of two cases,none of the TDFs even managed to provide a positive incremental return at all. In the two cases where the funds did produce a positive incremental return, the funds’ incremental costs exceeded such returns, making them cost-inefficient.

The plausibility analysis for the ten-year AMVR analysis not only shows the significant percentage disparity in incremental costs and incremental returns, but also how important it is for a fiduciary to factor in risk in order to obtain a meaningful “apples to apples” assessment and to avoid unnecessary exposure to fiduciary liability.

Interestingly, while pension plans and the financial services that argue for “apples to apples” comparisons, they generally dismiss risk-adjusted analyses. This plausibility chart may help explain why.

Going Forward
I am on record as saying that plan participants should never lose a properly vetted 401(k)/403(b) case. My position is based on the ease with which plan participants and their attorneys can establish both the plausibility and the legitimacy of the damages in their case through the use of the AMVR metric and plausibility analysis. Both analyses require nothing more than simple math and provide compelling evidence of any fiduciary breach. As John Adams said, “facts are stubborn things.”

Notes
1. Leber v. Citigroup 401(k) Plan Inv. Committee, 2014 WL 4851816.

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, consumer protection, cost consciousness, cost efficient, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary liability, fiduciary prudence | Tagged , , , , , , , , | Leave a comment

3Q 2022 AMVR “Cheat Sheets”: What Mutual Funds and Plan Advisers Hope Plan Sponsors and Plan Participants Never Realize

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

Given the recent performance of the markets, it should come as no surprise that the 5 and 10-Year AMVR analyses of the six most popular non-index mutual funds in U.S. defined contribution plans remain relatively unchanged.

Interesting to note that for both the 5 and 10-year period, only Vanguard PRIMECAP Admiral shares managed to qualify for an AMVR ranking.

Also interesting to note the importance of factoring in a fund’s risk-adjusted returns. On the 5-year AMVR analyses, factoring in risk-adjusted returns turned AF’s Washington Mutual Fund’s incremental return from (0.90) on nominal returns, to a positive 0.13. Admittedly, a small positive number, but still a significant change.

On the 10-year AMVR analyses slide, factoring in the fund’s risk-adjusted returns turned their incremental return from (0.57) (nominal) to 0.57 (risk-adjusted.) Likewise for Fidelity Contafund, where an incremental return of (0.79) (nominal) turned into a small, yet positive, 0.09.

Overall, the song remains the same, with the majority of actively managed funds being unable to overcome the combination of the weight of higher fees and cost and high r-squared/correlation of returns number to beat the index of comparable index funds

And so, we continue to see 401(k) actions alleging a breach of fiduciary duties by plan sponsors. Of note, we are seeing an increasing number of cases focusing on target date funds (TDFs). I expect to see more actions involving TDFs, as the AMVR provides compelling evidence of the imprudence of the active versions of such funds. I will post an updated analysis of the active and index versions of both the Fidelity Freedom and TIAA-CREF Lifestyle TDFs next week

I have often noted SCOTUS’ recognition that an ERISA fiduciary’s duties are “derived from the common law of trusts. In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts.”1

This statement from SCOTUS should not come as a surprise. Courts have often noted that ERISA is essentially a codification of the common law of trusts, as reflected in the Restatement of Trusts (Restatement). This similarity is especially noticeable in the fact that two consistent themes run throughout both of them-the importance of cost-consciousness and risk management.

As an ERISA attorney, I created the Active Management Value (AMVR) metric as a means of focusing on these topics in the context of fiduciary liability, specifically liability based on cost-inefficiency and ineffective risk management.

The basic AMVR is based primarily on the research of Charles D. Ellis and Nobel laureate Dr, William F. Sharpe. Dr. Sharpe has offered the following advice for analyzing the prudence of mutual funds:

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.2

Noted wealth management expert, Ellis, goes further, stating that

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!3

The financial services industry and 401(k)/403(b) plan advisers like to avoid the issues of fiduciary duties, transparency, and cost-inefficiency by avoiding comparisons of fund performance and only discussing returns in terms of nominal, or publicly stated, returns. Unfortunately, nominal returns are often misleading when fiduciary duties and potential fiduciary liability is involved.

AMVR FAQs
As the basic AMVR has gained increased recognition and use by investment fiduciaries and attorneys, there has also been increased recognition of the potential for the power of the advanced version of the AMVR, aka AMVR+. The basic AMVR is simply the cost/benefit analysis many of us used in our Econ 101 class, with the inputs being incremental costs and incremental returns.

In analyzing an AMVR analysis, the user only needs to answer two simple questions:

(1) Did the actively managed fund provide a positive incremental return?
(2) If so, did actively managed fund’s positive incremental return exceed the fund’s incremental costs.

If the answer to either of these questions is “no,” then, under the Restatement’s standards, the actively managed fund is imprudent relative to the benchmark index fund.

Here, the active fund’s incremental costs (72 basis points) exceed the fund’s incremental returns (5 basis points). “Basis points” is a term used in the financial services industry. I often tell people to just monetize the results by thinking in terms of dollars. Would you give someone $72 in exchange for $5. The prosecution rests.

Sadly, this scenario is common in 401(k)/403(b) plans. As a result, the number of ERISA actions against 401(k)/403(b) plans continues to increase.

The AMVR could easily help 401(k)/403(b) plans avoid such unnecessary liability exposure. Most AMVR analyses can be accomplished in 1-2 minutes and require no more than what one judge described as “third grade math…but very persuasive third grade math,” as he denied a plan’s motion to prevent the use of the AMVR in a 401(k) action.

Advanced AMVR Analysis
A well-known saying in the investment industry is that “amateurs focus on returns; professionals focus on risk management.” Search “investment risk management Charles D. Ellis” and you will find his familiar statement that the secret of successful investing is the informed management of investment risk. Perform the same search using the names of investment icons Benjamin Graham and Paul Tudor Jones and you will find similar statements.

Plan sponsors and other investment fiduciaries are gradually recognizing the power of the AMVR as a risk management tool. The advanced version of the AMVR, AMVR+, addresses three types of risk:

1. The risk of cost-inefficiency,
2. The risk of underperformance, and
3. The risk of the investment risk, aka volatility.

The Risk of Cost-Inefficiency
The basic premise of cost-inefficiency is simple to express–costs exceeding benefits/returns. In connection with investing and the AMVR, it is incremental costs exceeding incremental benefits aka returns. An investment in a cost-efficient investment means an investor would actually be losing money. The fact that costs, like returns, compound over time only exacerbates the investment risk and resulting damage.

While many people continue to debate the relative merits of active management versus passive management, I maintain that issue is, and always has been, a meaningless debate. The more meaningful question is cost-efficiency versus cost-inefficiency.

A cost-inefficient investment can never be a prudent investment choice, especially for an investment fiduciary. Even the Restatement acknowledges this fact.

The cost-inefficiency of many actively managed funds may be even worse than it appears at first glance. Ross Miller’s Active Expense Ratio suggests that the effective expense ratio of many actively managed funds is often understated by as much as 400-500 percent. Miller explained the importance of the Active Expense Ratio and AW as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.4

The Risk of Underperformance
Again, a simple concept. An actively managed fund that fails to provide a positive incremental return when compared to a comparable index fund represents an opportunity cost equal to the incremental return that could have been realized by investing in the better performing index fund.

Studies have consistently shown that the overwhelming majority of actively managed funds underperform comparable index funds.5 Given the higher costs typically associated with active management, including higher management fees and trading costs, these findings should come as no surprise, especially given the high correlation of returns between most U.S. domestic equity funds and their index counterparts.

The high correlation of return, often 95 and above, raises the issue of potential “closet indexing.” Closet indexing refers to the practice of actively managed funds marketing the benefits of the active management they allegedly provide, only to provide similar, in many cases lower returns. than a comparable index fund

Correlations of 95 and above raise genuine issues of whether active management was provided at all, and the issue of exactly how much active management was provided. Ross Miller’s Active Expense Ratio metric calculates the Active Weight (AW), or the percentage of active management provided by a fund. AW can be calculated simply through the use of an actively managed fund’s expense ratio and its r-squared, or correlation of returns, number.

With so many active funds having a correlation of 95 and above to comparable index funds, it is interesting to note the estimated AW of such funds. Miller found that there is not a one-to-one correlation between r-squared to the percentage of active management provided. For instance, Miller found that active funds with a correlation number of 98 only provide an estimated 12.50 percent in active management.

Miller’s studies clearly demonstrate the value of factoring in correlations of return between actively managed funds and comparable index funds. This is why we use Miller’s Active Expense Ratio in calculating correlation-adjusted costs in order to provide a more meaningful cost-efficiency analysis in our AMVR+ analyses.

The Risk of Investment Risk/Volatility
Studies have consistently shown that investment returns are influenced by the level of investment risk assumed, the so-called risk-return equation.

Section 90, comment h(2). of the Restatement (Third) of Trusts is a fundamental principle of fiduciary law and prudent investing. Section 90(h)(2) states that the use of actively managed strategies is imprudent unless it can be reasonably predicted that the active strategy will provide a commensurate return for the additional costs and risks typically associated with active investing.

As mentioned previously, most actively managed funds simply cannot meet this requirement, due largely to the burden of higher management fees/expenses and trading costs. This is the reason InvestSense factors in a fund’s risk-adjusted return in our AMVR+ cost-efficiency analyses. While many advocates of active management dislike the use of risk-adjusted returns, the fact is that factoring in risk often improves the cost-efficiency numbers for actively managed funds since it is a factor that they can actually control.

Going Forward
The evidence clearly establishes the potential benefits of the AMVR and AMVR for investment fiduciaries, attorneys, and investors. Investment fiduciaries can avoid unnecessary and unwanted fiduciary liability exposure. Attorneys and easily establish the merits of their case and comply with applicable pleading standards. Investors can analyze the prudence of their investment and hopefully better protect their financial security.

Notes
1. Tibble v. Edison International, 135 S. Ct 1823 (2015)
2. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
3, Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
4. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
5. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010); Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8e; Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997); Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016.

Posted in fiduciary compliance | Leave a comment

SCOTUS, We Still Have a Serious Problem: The Continuing Inconsistency in Judicial Interpretations of ERISA

Just when you thought it was safe to go back in the water, the Sixth Circuit issues its decision in Smith v. CommonSpirit Health (CommonSpirit).1 The Sixth Circuit dismissed the plan participant’s action, largely upon the familiar argument that market indices and/or comparable index funds are not “meaningful benchmarks” for the purposes of 401(k) litigation.

That issue was supposedly resolved by the combination of the First Circuit’s Brotherston decision2 and SCOTUS’ subsequent denial of Putnam’s application of certiorari for review.3 When SCOTUS denies an application for certiorari, it is generally understood that the Court approves of both the lower court’s decision and the rationale behind the decision.

In Brotherston, Judge Kayatta offered a well-reasoned decision with regard to why market indices and/or comparable index funds are appropriate for benchmarking purposes in 401(k) litigation.

The recovery from a trustee for imprudent or otherwise improper investments is ordinarily ‘the difference between (1) the value of those investments and their income and other product at the time of surcharge and (2) the amount of funds expended in making the improper investments, increased (or decreased) by a projected amount of total return (or negative total return) that would have accrued to the trust and its beneficiaries if the funds had been properly invested.’ Id. § 100 cmt. b(1). Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes ‘return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).’4

ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for ‘any losses to the plan resulting from each such breach.’ 29 U.S.C. § 1109(a). Certainly, this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent ‘to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.’ And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts. 

In this instance, the trust law that we have described provides an answer that both requires no stretch of ERISA’s text and accords with common sense.6

So, to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes);…7

The Sixth Circuit offered no explanation in its CommonSpirit decision as to why the Brotherston decision, and SCOTUS’ subsequent refusal to review said decision was not applicable. The court simply ignored the First Circuit’s decision regarding the fiduciary prudence and benchmarking argumwent. While Circuit Courts of Appeal are not obligated to follow the decisions of other circuits, one could argue that the First Circuit’s reliance on the Restatement (Third) of Trusts (Restatement), and SCOTUS’ refusal to hear Putnam’s appeal, are compelling reasons to follow the rationale expressed in Brotherston.

As a fiduciary risk management consultant that offers fiduciary oversight services to 401(k) a nd 403(b) plans, the CommonSpirit decision concerns me for several reasons. First, based on the Brotherston decision and SCOTUS’ denial of certiorari, I believe that SCOTUS will ultimately expressly adopt the Restatement’s position and rule that market indices and comparable index funds are appropriate for benchmarking purposes in 401(k) litigation.

Second, if SCOTUS does adopt this position, then plan sponsors will find themselves in the same position they have found themselves in after SCOTUS’ decision in Hughes v. Northwestern University8 – utterly defenseless to breach of fiduciary prudence claims. The fact that a plan sponsor relies on the Sixth Circuit’s decision, or any other court decision subsequently vacated, will not serve as a defense to fiduciary breach claims. Courts face no legal liability for decisions subsequently vacated.

Some plan sponsors have asked me whether they have legal recourse against plan providers/advisers that led them to believe they could rely on a court’s decision. While SCOTUS has ruled that plans may sue plan providers/advisers based on common law principles such as negligence, fraud, and breach of contract, nothing is guaranteed.9

We have seen several instances where plan providers/advisers have voluntarily agreed to cover half of any damages awarded as a result of 401(k) litigation. Whether that trend will continue is uncertain.

Going Forward
My primary criticism of decisions such as the CommonSpirit decision is that they create a false of security, resulting in plan sponsors failing to seek proper legal advice to protect themselves and the plan’s participants. This is especially true in situations such as CommonSpirit, when the applicable legal standard has arguably been previously established and endorsed by SCOTUS.

That said, plan sponsors have a duty to understand and fulfill their fiduciary duties to the plan and the plan’s participants. If a plan sponsor chooses to rely on conflicted plan providers and advisers, rather than experienced ERISA attorneys, then the plan sponsor has to accept the consequences for such decisions.

Unfortunately, it appears that the CommonSpirit decision will not be appealed to SCOTUS. As a result, more 401(k) plans and plan sponsors will needlessly be exposed to unlimited personal liability unless and until SCOTUS does rule that market indices and comparable index funds are appropriate benchmarks in 401(k) litigation under the Restatement.

Notes
1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022).
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 1stt Cir. 2018)
3. Putnam Investments, LLC v. Brotherston – SCOTUSblog
4. Brotherston, 31.
5. Brotherston, 31.
6. Brotherston, 32.
7. Brotherston, 34.
8. Hughes v. Northwestern University, 142 S.Ct. 737 (2022).
9. Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 90 103 S.Ct. 2890 (1983).

Posted in 401k, 401k compliance, 401k investments, 401k plan design, 401k risk management, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, pension plans, plan sponsors, risk management | Tagged , , , , , , , , , , , , | Leave a comment

Fiduciary Risk Management and Liability-Driven 401(k) Plan Design

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

I have written several posts on this blog critiquing the Sixth Circuit’s decision in Smith v. CommonSpirit Health (CommonSpirit). The decision, particularly the court’s “apples and oranges” argument is inconsistent with the both the First Circuit’s decision in Brotherston v. Putnam Investments, LLC, and the Restatement (Third) of Trust’s explicit approval of index funds for benchmarking purposes by fiduciaries. The fact that SCOTUS denied Putnam’s petition for certiorari clearly indicates that the Court agrees with both the First Circuit’s decision and the rationale behind the decision.

In retrospect, I believe the CommonSpirit decision may have done plan participants and ERISA plaintiff’s attorney a favor by opening “Pandora’s Box” as to a common issue with some 401(k)/403(b) plans and plan advisers/providers, that question being

Are plan sponsors and ERISA plaintiff’s attorneys overlooking a potentially significant breach of a plan sponsor’s fiduciary duties of loyalty and prudence?

ERISA case law is very clear that a plan sponsor’s fiduciary duties extend to the selection and monitoring of a plan’s plan advisers and providers.

[W]here the trustees lack the requisite knowledge, experience and expertise to make the necessary decisions with respect to investments, their fiduciary obligations require them to hire independent professional advisors….1

Failure to utilize due care in selecting and monitoring a fund’s service providers constitutes a breach of a trustees’ fiduciary duty. At the very least, trustees have an obligation to (i) determine the needs of a fund’s participants, (ii) review the services provided and fees charged by a number of different providers and (iii) select the provider whose service level, quality and fees best matches the fund’s needs and financial situation.  Trustees also have an ongoing obligation to monitor the fees charged and services provided by service providers with whom a fund has an agreement, to ensure that renewal of such agreements is in the best interest of the fund.2

In the recent CommonSpirit decision, it appears that that very issue was never raised by plaintiff’s attorney. The issue may have been raised implicitly or collaterally in addressing other alleged fiduciary breaches. To be honest, I do not even remember a case where that specific issue was raised as a separate fiduciary breach by a plan sponsor.

I believe the timing is right to address the following question: Does a plan sponsor breach their fiduciary duties of loyalty and prudence if they select and/or maintain a plan adviser and/or provider who is affiliated with an investment company that offers various investment products for a 401(k)/403(b) plan, but the investment company does not make available all of its investment products to such plans, effectively forcing them to settle for less prudent investment products in order to financially benefit the investment company and/or the plan adviser/provider

In CommonSpirit, the primary issue involved the plan’s choice of the active suite of Fidelity Freedom TDF funds. A forensic analysis comparing the active suite of the Fidelity Freedom 2035 TDF to the comparable index version of the same fund is shown below. InvestSense’s proprietary metric, the Active Management Value Ratio (AMVR), was used to perform the forensic analysis.

The combination of underperformance relative to the index version and the incremental cost, with no commensurate return at all, would indicate that the active suite version is cost-inefficient relative to the index version of the fund and, thus, imprudent.

And yet, the plan sponsor chose and continued to offer the active suite of Fidelity Freedom TDFs within the plan. Based on the discussion within the decision, Fidelity may not make the index version of the Fidelity Freedom TDFs available to 401(k) or 403(b) plans.

A similar AMVR analysis of several of the other active suite Fidelity Freedom TDFs suggests that the funds analyzed are also imprudent based on cost-inefficiency.

The results shown on the two slides raise obvious questions with regard to possible fiduciary breaches by the CommonSpirit plan sponsor and other plan fiduciaries. Even if Fidelity does not allow the Fidelity Freedom index funds within 401(k) plans, that would not excuse a plan sponsor ignoring the findings from the AMVR forensic analyses. Fidelity clearly had more prudent investment options available. Fidelity apparently simply chose not to offer them to CommonSpirit to financially benefit their own investment company.

As SCOTUS stated in its Northwestern University decision, each individual investment option must be prudent. A plan sponsor has an ongoing duty to monitor all investment options offered within its plan and promptly remove any imprudent option.

Fidelity’s Contrafund fund (Contrafund) has long been one of Fidelity bellwether funds, both in retail accounts and pension plans. Of note, Morningstar recently downgraded the fund.

Fidelity created a series of index funds to compete with Vanguard’s popular index funds. Fidelity’s index funds have proven to be a true competitor to Vanguard’s index funds, both in terms of price and performance.

Morningstar rates Contrafund as a large cap growth (LCG) fund. Fidelity offers a comparable LCG index fund. Using the AMVR metric, a forensic analysis comparing the two LCG Fidelity funds provided some interesting results.

Once again, the actively managed Fidelity fund proved to be imprudent relative to a comparable Fidelity index fund. Keep in mind, in assessing the damages of a fiduciary breach, the underperformance of an actively managed fund is properly considered as an opportunity cost. Therefore, the underperformance is combined with the incremental costs of the actively managed funds in computing potential damages resulting from a fiduciary breach.

Rethinking the Fiduciary Disclaimer Clause
During my fiduciary audits of 401(k) and 403(b) plans, I always review the plan’s advisory contract. More often than not, I find that the plan advisor has inserted a fiduciary disclaimer clause in the contract. As a result, the plan advisor will claim that any advice and services that they provide to a plan is not required to meet the stringent fiduciary standard’s loyalty and prudence requirements.

More often than not, I find that the advice and services provided by the plan advisor has definitely not met such standards. As a result, the plan sponsor is left fully exposed for all fiduciary liability.

When I point out the fiduciary disclaimer clause in their advisory contract and its implications, the plan sponsor will quickly claim that they were not aware of such language and would never have agreed to such conditions. The challenge for plan sponsors is in detecting such language, as it rarely clearly set out.

Fiduciary disclaimer language is often buried within the advisory contract and stated in such a way as not to arouse suspicion. An example of some commonly used language is often along the line of

“Plan, plan sponsor and plan adviser hereby acknowledge and agree that plan adviser shall only provide advice to the plan and plan sponsor, and that plan and plan sponsor alone shall be responsible for making the ultimate responsibility as to whether to implement plan advisers’ advice and recommendations, in whole or in part.”

Translated – we disclaim all fiduciary responsibilities regarding the plan, plan sponsors, or any plan participants. Fiduciary disclaimer clauses are often, but not always, expressed in negative terms, what they will not provide.

People often accuse me of picking on Fidelity in connection with 401(k) and 403(b) plans. Let me be clear, Fidelity has some excellent products. In taking advantage of a fiduciary disclaimer clause to avoid any fiduciary liability by only offering 401(k) and 403(b) plans, they are simply doing what plan sponsors should be doing – protecting their best interests. That said, plan sponsors may still have recourse against plan advisers and providers. through the courts plan sponsors based on legal grounds such as breach of contract, negligence, and fraud

Liability-Driven 401(k) Plan Design
My experience has been that plan sponsors rarely consult with ERISA attorneys regarding fiduciary risk management and designing a liability-driven plan, a win-win plan that both reduces their personal risk while also ensuring a plan that genuinely promotes and protects the best interests of their plan participants.

Marcia Wagner is one of America’s top ERISA attorneys. I first heard about the liability-driven ERISA plan design concept when I read an excellent Lexis-Nexis article she co-wrote with Barry Saelkin. The article itself focused on using the liability-driven concept in selecting investments for defined benefit plans. As I read the article, I realized how perfectly the concept dovetailed with the AMVR metric in connection with defined contribution plans.

Two key points from the article regarding liability-drive plans:

(1) plan sponsors should always employ effective “de-risking” techniques and strategies to minimize the potential liability exposure they may face from selecting and monitoring investment options within a plan;
(2) plans should always hire independent and experienced outside experts to help them design, monitor and maintain an effective liability-driven plan.

Ask any experienced ERISA attorney and they will tell you that most ERISA plans will mistakenly tell you that they are ERISA compliant. Plan sponsors and plan investment committees quickly realize otherwise when I show them the results of my AMVR forensic analyses and my fiduciary prudence audit.

Plan sponsors typically ask what they could have/should have done differently. In addition to having originally designed the plan using liability-driven concepts, I usually remind them that the plan adviser/provider would have been a co-fiduciary with the same fiduciary liability responsibilities and exposure – had the plan not released them from such duties by virtue of the fiduciary disclaimer clause. The clause arguably allowed them to provide the plan with imprudent, substandard advice and services – with arguably no liability to the plan.

Going Forward
I am a firm believer in the liability-driven plan concept for fiduciary accounts, including 401(k) and 403(b) plans. Plan advisers typically emphasize the nominal returns of their recommendations, with little or no discussion of the potential risks and liabilities associated with such recommendations, e.g., excessive volatility, overall cost-inefficiency, and other unsuitability concerns. The liability-driven plan concept should be even more appealing as the number of ERISA actions continue to increase.

The bad news is that most plans have no idea just how much potential personal liability is hidden in their current plan. The good news is that it is relatively easy to design, implement and maintain a liability-driven 401(k) or 403(b) plan. Furthermore, by using liability-driven concepts to “de-risk” a 401(k)/403(b) plan, a plan can be designed to provide significant benefits for both plan sponsors (risk management and reduced potential liability exposure) and plan participants (improved investment performance).

Notes
1. Liss v. Smith, 991 F.Supp 278, 297 (S.D.N.Y. 1998). 
2. Liss, 300.

© 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, 401k plan design, 401k risk management, 403b, Active Management Value Ratio, AMVR, 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, fiduciary risk management, fiduciary standard, investment advisers, investments, Mutual funds, pension plans, plan sponsors, prudence, risk management, wealth management, wealth preservation | Tagged , , , , , , , , , , , | Leave a comment

Brotherston v. CommonSpirit Health: An Opportunity, and a Need, to Shift the 401(k) Litigation Paradigm

In the midst of chaos, there is also opportunity – Sun Tzu

As an ERISA attorney, the Sixth Circuit’s recent CommonSpirit Health (CommonSpirit) decision1 concerns me. First, the Court completely ignored the First Circuit’s Brotherston decision2, the Restatement (Third) of Trusts (Restatement), and SCOTUS’ subsequent denial of Putnam’s appeal of that decision.

Second, the fact that the CommonSpirit decision has revived the meritless “apples and oranges” argument regarding fiduciary prudence, even though both the Brotherston decision and SCOTUS’ denial of cert discredited such an argument. As a result, the Sixth Circuit has arguably created an unnecessary divide within the circuits.

Upon a recent re-reading of the CommonSpirit decision, I realized that the Sixth Circuit may have actually provided a valuable opportunity to provide more certainty for plan sponsors and to clarify the guidelines going forward for 401(k)/403(b) administration and litigation.

Brotherston v. Putnam Investments, LLC

The Restatement calls “for determining whether and in what amount the breach has caused a `loss’ . . . by reference to what the results `would have been if the portion of the trust affected by the breach had been properly administered.'”3 

Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes “return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).”4 (citing § 100 cmt. b(1)

ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for “any losses to the plan resulting from each such breach.” Certainly this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent “to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.”5 (cjtes omitted)

And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts. (citing Varity Corp. v. Howe, 516 U.S. 489, 496-97, 502, 506-07 (1996) (relying on “ordinary trust law principles” to fill gaps created by ERISA’s lack of definition regarding the scope of fiduciary conduct and duties).6

[T]he burden of showing that a loss would have occurred even had the fiduciary acted prudently falls on the imprudent fiduciary. By allowing its analysis on loss to be driven by its concern regarding the objective prudence of the Putnam funds, the district court in essence required plaintiffs to show causation as part of its case on loss-even as it correctly sought to reserve that requirement to defendants.7

So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes).8

In concluding, Judge Kayatta made two significant points:

The Supreme Court has time and again adopted ordinary trust law principles to construe ERISA in the absence of explicit textual direction.9

[T]he Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits…. In other words, Congress sought to offer beneficiaries, not fiduciaries, more protection than they had at common law, albeit while still paying heed to the counterproductive effects of complexity and litigation risk.10

CommonSpirit Health

Trust law informs the duty of prudence, as “an ERISA fiduciary’s duty is derived from the common law of trusts.”11

[The federal pleading] rules require the plaintiff to provide sufficient “facts to state a claim to relief that is plausible on its face.” Plausibility requires the plaintiff to plead sufficient facts and law to allow “the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.”  “The plausibility of an inference depends on a host of considerations, including common sense and the strength of competing explanations for the defendant’s conduct.”12

Even if CommonSpirit did not violate a fiduciary duty by offering actively managed plans in general, it is true, the company still could violate ERISA by imprudently offering specific actively managed funds. ERISA, in other words, does not allow fiduciaries merely to offer a broad range of options and call it a day. While plan participants retain the right to choose which fund is appropriate for them, the plan must ensure that all fund options remain prudent options.13

Nor does a showing of imprudence come down to simply pointing to a fund with better performance. We accept that pointing to an alternative course of action, say another fund the plan might have invested in, will often be necessary to show a fund acted imprudently (and to prove damages). But that factual allegation is not by itself sufficient. In addition, these claims require evidence that an investment was imprudent from the moment the administrator selected it, that the investment became imprudent over time, or that the investment was otherwise clearly unsuitable for the goals of the fund based on ongoing performance.14

That is why disappointing performance by itself does not conclusively point towards deficient decision-making, especially when we account for “competing explanations” and other “common sense” aspects of long-term investments. In context, such allegations standing alone do not move the claim from possible and conceivable to plausible and cognizable.15 

We would need significantly more serious signs of distress to allow an imprudence claim to proceed….publicly available performance information about an investment may show sufficiently dismal performance that this reality, when combined with ‘allegations about methods,’ will successfully allege that a prudent fiduciary would have acted differently.16

An Opportunity Out of Chaos?
Most 401(k) litigation focuses on the nominal returns of the investment options within a plan. Both the First Circuit and the Sixth Circuit agree on the importance of trust law in interpreting ERISA. As the Brotherston decision points out, the Restatement explicitly authorizes the use of index funds as comparators, discrediting the “apples and oranges” argument.

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

  • A fiduciary has a duty to be cost-conscious.17
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.18
  • Actively managed mutual funds that are not cost-efficient, that cannot be “justified by realistically evaluated expectations” to provide a commensurate return for the additional costs abd risks typically associated with active management are imprudent.19

Given these guidelines, the research on the cost-efficiency of actively managed mutual funds suggest that plan sponsors face a daunting challenge in trying to justify the inclusion of actively managed mutual funds in a 401(k) plan:

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.20
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.21
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.22
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.23

However, the Sixth Circuit insisted on “more serious signs of distress” and the use of publicly available performance information to show “sufficiently dismal performance” to establish that a plan sponsor breached their fiduciary duties

The Active Management Value Ratio™
I have suggested for some time that the Active Management Value Ratio (AMVR) is a valuable tool in analyzing the prudence of plan sponsors and other investment fiduciaries. The CommonSpirit decision seems to be the perfect opportunity to prove my assertions.

As I have noted in previous posts on this site, the AMVR is based on the investment research of investment notables such as Nobel Laureate Dr. William F. Sharpe, Charles D. Ellis, Burton L. Malkiel, and Ross Miller. The fundamental premise behind the AMVR is cost-efficiency, a criticial factor in assessing fiduciary prudence under the Restatement.

As Ellis has consistently suggested,

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!24

A sample of an AMVR analysis supports Ellis’ position.

When I perform an AMVR analysis, I provide two sets of numbers, one set being based on the funds’ nominal, or publicly reported, numbers, the other set being based on the funds’ correlation-adjusted costs and risk-adjusted returns. Experience has shown that the investment and 401(k) industries typically prefer the nominal numbers, while ERISA plaintiff attorneys prefer the adjusted numbers.

The AMVR is simple and straightforward, requiring only the ability to compare the data between an actively managed fund and a comparable index fund by simple subtraction. A plan sponsor, or any other investment fiduciary, then just has to answer two simple questions:

  1. Did the actively managed funds provide a positive incremental return?
  2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs?

If the answer to either question is “no,” then the actively managed fund is cost-inefficient/imprudent relative to the comparable index fund.

The AMVR slides speak for themselves. Situations where an investment’s incremental costs exceed its incremental returns is never a desirable, or prudent, investment scenario. Cost-inefficient investment alternatives within a 401(k) plan are not legally valid “choices.” Additional details on the calculation and interpretation of the AMVR are available on this website.

In CommonSpirit, the primary issue was the alleged imprudence/ cost-ineffficiency of Fidelity’s Freedom Funds (Active Suite) compared to Fidelity’s Freedom Funds Index Funds. I performed an AMVR analysis on several of the funds to determine the merits of the plaintiffs’ case.

The results of an AMVR analysis on several of the other Freedom funds provide similar results.

The AMVR analyses clearly show that in most cases the Active Suite not only underperformed the comparable index shares, but such opportunity cost/loss was further compounded by the fact that an investor incurred additional incremental costs in connection with such funds, while receiving actually nothing in return for such costs. This is the antithesis of fiduciary prudence.

The situation becomes even worse if the costs are adjusted for the correlation between the active suite funds and the comparable index funds, shown here based on Miller’s Active Expense Ratio (AER). Miller described the importance of the AER:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.25

The second slide shows just how much of an impact the combination of a fund with high incremental costs and a high correlation of returns can have on the effective costs that an investor pays for a active management, further reducing the cost-efficiency of an investment and overall prudence.

Going Forward: An Opportunity Amidst Chaos
The Sixth Circuit has created a division between itself and the First Circuit on the issue of whether index funds are valid comparators, “meaningful benchmarks,” in 401(k) actions. The two circuits do agree with SCOTUS that the common law of trusts provides insight on fiduciary law issues, including on questions involving fiduciary prudence. The two circuits also agree on the importance of costs.

The Restatement is just that, a restatement of the common law of trusts. In Tibble26, SCOTUS specifically noted that the courts often turn to the Restatement for guidance in resolving questions involving fiduciary law, including questions involving ERISA.

As the First Circuit noted, Section 100 the Restatement expressly approves of the use of index funds as comparators in 401(k) litigation. The AMVR can be used by plan sponsors and attorneys to easily prove that in the overwhelming majority of cases, the inclusion of actively managed mutual funds in a 401(k) plan cannot satisfy the Restatement’s requirement that the use of actively managed funds/strategies be justifiable by “realistically evaluated return expectations” of providing a commensurate return for the additional costs and risks associated with active management, are imprudent.

“Wilful blindness” is a legal term often defined as “a conscious avoidance, a judicially-made doctrine that expands the definition of knowledge to include closing one’s eyes to the high probability a fact exists.” Despite acknowledging the importance of the common law of trusts, the Sixth Circuit has seemingly decided to ignore the Restatement’s positions with regard to both index funds as acceptable benchmarks in 401(k) litigation and the concerns over a fiduciary’s use of active management strategies and/or products. However, “facts do not cease exist because they are ignored.”

The Sixth Circuit states asserts that plaintiffs must do more than simply pleading the underperformance of an actively managed fund. Under the federal pleading rules, the Sixth Circuit says that in order to satisfy federal pleading rules, plan participants must plead facts that establish the plausibility, not just the possibility, that a plan sponsor breached of their fiduciary.

The AMVR provides plan plaintiffs and their attorneys with a simple means to provide the “more” that both the Sixth Circuit and the plausibility pleading standard demand. By combining the AMVR with the overwhelming research establishing the cost-efficiency of actively managed, plan participants can establish both the underperformance of actively managed funds, and the resulting cost-efficiency of such funds due to the fact that such funds’ incremental costs exceeding incremental returns, if any, provided by such funds.

The AMVR also eliminates the need for courts and plan sponsors to consider immaterial collateral issues such as a fund’s classification (active, passive, large cap, small cap) and/or investment strategy (growth, income), as the use of cost-efficiency as the comparator cuts across such factors to provide an evaluation based on the stated purpose of ERISA, that being the best interests of the plan participants and their beneficiaries.

The plaintiffs have not announced whether they intend the to appeal the Sixth Circuit’s CommonSpirit decision. I hope that the decision is appealed in order to shift the paradigm in connection with 401(k) plans and to clarify the applicable standards in 401(k) and 403(b) litigation.  Such a final resolution would provide much needed clarity for both plan sponsors and the courts as to the applicable guidelines for plan administration and allow plan sponsors to design win-win 401(k)/403(b) plans that actually promote the best interests of both plan participants and plan sponsors.

Copyright InvestSense, LLC 2022. All rights reserved.

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

Notes
1. Smith v. CommonSpirit Health, No. 21-5964, June 21, 2022 (6th Cir. 2022). (CommonSpirit)
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
3. Brotherston, 31.
4. Brotherston, 31.
5. Brotherston, 31.
6. Brotherston, 33.
7. Brotherston, 34.
8. Brotherston, 36.
9. Brotherston, 36.
10. Brotherston, 37.
11. CommonSpirit, Section II.A.
12. CommonSpirit, Section II.A.
13. CommonSpirit, Section II.A.
14. CommonSpirit, Section II.A.
15. CommonSpirit, Section II.A.
16. CommonSpirit, Section II.A.
17. Restatement (Third) Trusts, Section 90, Introductory Comment. American Law Institute. All rights reserved. (Restatement)
18. Restatement, Section 90 cmt. f. All rights reserved.
19. Restatement, Section 90 cmt. h(2). All rights reserved.
20. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
21. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
22. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
23. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
24. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
25. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
26. Tibble v. Edison International, 135 S. Ct 1823 (2015).

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, AMVR, cost consciousness, cost-efficiency, Cost_Efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary duty, fiduciary law, fiduciary liability, fiduciary liability, Fiduciary prudence, fiduciary prudence, fiduciary responsibility, fiduciary risk management, fiduciary standard, Mutual funds, pension plans, plan sponsors, prudence, risk management, SEC, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , | 1 Comment

The Conversation Every 401(k) and 403(b) Plan Needs to Have: The Plan Sponsor Liability Circle™

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

Whenever plan sponsors and plan advisers talk about 401(k) litigation, they always point the finger at those bad ‘ol ERISA plaintiff attorneys. Since I am one of those bad folks, I respectfully disagree with such sentiments. I respectfully suggest that plan sponsors should look in the mirror to see the real party for such litigation. As the famous comic strip, “Pogo,” once said, “we have met the enemy and he is us.”

Whenever I talk with a CEO and/or a 401(k) investment committee, this is the first graphic I show them.

Most plan advisers insist on plan sponsors agreeing to an advisory contract that contains a fiduciary disclaimer clause. Many plan sponsors are not aware that they have agreed to such a provision since the clauses are usually set out in legalese. But they are usually there.

When a plan sponsor agrees to such a clause, it waives important protections for both itself and the plan participants. With a fiduciary disclaimer clause, securities licensed advisers can claim to be subject to Regulation “Best Interest” (Reg BI) rather than the more demanding duties of loyalty and prudence required under a true fiduciary standard.

Reg BI claims that it requires brokers to always put a customer’s best interests first, including considering the costs associated with any and all recommendations. Then Reg BI turns around and allows brokers to only consider “readily available alternatives,” which the SEC considers to include the cost-inefficient and consistently underperforming actively managed mutual funds and various annuity products that brokers and broker-dealers generally recommend. So, in whose best interests?

Unless a plan sponsor properly performs the investigation and evaluation required under ERISA, this usually results in 401(k) litigation and the plan sponsor settling for a significant amount. As we discussed in a previous post, when you consider that all of this can be easily avoided by a plan sponsor by performing a cost-efficiency analysis using our free Active Management Value Ratio, you have to wonder why plan sponsors do not better protect themselves by simplifying their plans and ensuring that they are ERISA-compliant.

My experience has been that most plan sponsors create unnecessary liability exposure for themselves due to a mistaken understanding of their true fiduciary duties. “The CommonSense 401(k) Plan”™ provides a simple solution that reduces both administration costs and potential liability exposure, resulting in a win-win situation for both plan participants and plan sponsors.

So, for plan sponsors and plan advisers, the next time you point a finger at ERISA plaintiff’s attorney and blame us for the number of 401(k) litigation cases, remember the words of my good friend, Charles Nichols, when you point at us, three of your remaining fingers point back at you.

Copyright InvestSense, LLC 2022. All rights reserved.

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

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, best interest, 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, fiduciary risk management, fiduciary standard, investment advisers, Mutual funds, pension plans, plan sponsors, prudence, Reg BI, retirement planning, retirement plans, risk management, securities compliance | Tagged , , , , , , , , , , , , , , , | Leave a comment