“Apples to Apples” and Other Investment Return Issues

I just finished reading Judge Doty’s decision dismissing the Wells Fargo 401(k) excessive fees action and the complaint filed in the new Capital Group/American Funds 401(k) breach of fiduciary duties action. Just seems to be further evidence that we have a lot of people saying a lot of different, and seemingly inconsistent, things about the same law, ERISA. First thing that comes to mind…are these irreconcilable differences? Second thing that comes to mind…what are the takeaways for plan sponsors and other investment fiduciaries?

OK, let’s be honest. The law clearly states that plan sponsors must perform an independent and prudent investigation and evaluation of investment options chosen for their plan.

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard….The failure to make an independent investigation and evaluation of a potential plan investment is a breach of one’s fiduciary duty.(1)

The law goes on to state that a plan sponsor cannot blindly rely on information and advice from third parties, stating that

“One extremely important factor is whether the expert advisor truly offers independent and impartial advice.” (2)

“blind reliance on [a] broker whose livelihood [is] derived from the commissions he [is] able to garner [is] the antithesis of such independent investigation.”(3)

And yet most people with any experience in the ERISA/pension field know that most plan fiduciaries do not know how to properly vet a mutual fund and/or they routinely blindly accept whatever a plan provider tells them about an investment option. That’s exactly why so many of the 401(k) excessive fee cases settle, as the breach of the plan’s fiduciary duties is blatantly obvious.

In most of the 401(k) fee cases, the plaintiff uses Vanguard’s funds as their benchmarks in evaluating the prudence of a plan’s investment options. Vanguard is an obvious choice given their low fees and their excellent relative performance record. Several courts have recently rejected the use of Vanguard’s funds for benchmarking purposes, claiming that Vanguard and fund companies that offer actively managed funds have different business platforms and business objectives.

With all due respect, as we say in the South, “that dog don’t hunt.” Last time I checked, Vanguard is not a 503(c) non-profit corporation. Like all mutual fund companies, Vanguard seeks profits. Vanguard has simply realized that it can make a profit by combining good performance with lower costs, a combination that is exactly in line with ERISA’s goals and purpose.

Interestingly enough, some studies have shown that a number of actively managed funds do manage to outperform comparable index until fees and other costs are considered. So an actively managed fund’s decision to charge higher fees than Vanguard, resulting in lower returns to investors, should in no reduce the viability of Vanguard’s funds for benchmarking purposes. Hopefully, this narrow-sighted and meritless rejection of Vanguard funds for benchmarking purposes will be corrected by the federal appellate courts.

Investment Returns Primer
What the courts, plan sponsors and other investment fiduciaries have to do is show a better understanding of various forms of investment returns and be aware of how some actively managed mutual funds deliberately misuse the forms of returns to confuse and mislead investors. By pure coincidence, I had been alerted by some of my colleagues to various posts and ads that American Funds has recently run.

In one ad they based their long-term performance claims on the funds’ nominal returns. However, since they were using their funds’ A shares, which charge a 5.75% front-end load, the funds’ load-adjusted returns were the appropriate measure to use for comparison purposes with other benchmarks. At the bottom of the ad, in small type, there was a disclosure stating that returns would have been lower had load-adjusted returns been used. However, there was no disclosure of the actual load-adjusted returns, thereby denying an investor with the material information needed to make an informed investment decision.

In another ad touting the long-term performance of American’s funds, American Funds calculated their funds’ performance using their current 5.75% front-end load, even though they stated that the returns were based, in part, on a time period when they charged a front-end load of 8.50%. By using the improper front-end load percentage, American Funds was able to quote a higher annualized return. My concern is that many investors may have missed this error and/or not understood the implications.

In reading some of the 401(k) cases, it is clear to me that some courts are not properly addressing the full range of investment returns issues involved in many of these 401(k) excessive fees cases. One recurring issue is the fact that courts are labeling various ranges of 401(k) plan fees as falling within an “acceptable” range. To the best of my knowledge, ERISA does not designate any range of fees as “acceptable.”

As the courts frequently point out, fees should not be viewed in terms or absolute value alone. And yet, that’s exactly what some courts are doing on an increasing basis. As TIAA-CREF pointed out in an excellent white paper addressing the reasonableness of plan fees,

Plan fiduciaries are required to determine whether fees are “reasonable” for the services provided and that the services support their plan goals…. Plan sponsors are required to look beyond fees and determine whether the plan is receiving value for the fees paid.(4)

In most cases a court will reference a range of fees that was found to be “acceptable” in another 401(k) fees actions. The obvious problem with that is that the facts of each case are usually different, including the value, if any, of the services or performance being provided to a plan and plan participants in exchange for the fees being paid. The Restatement states that a fiduciary should not select a program using actively managed mutual funds unless that fiduciary has a reasonable and justifiable belief that that the program will provide the plan and plan participants with benefits that are commensurate with the added cost of risk of active management plan.(5)

Since plan sponsors are fiduciaries, they are held to the fiduciary duties of loyalty and prudence, including the “best interest” and “prudent investor” standards. In many cases, actively managed funds have a history of combining significantly higher fees and relative underperformance when compared to comparable index funds. This combination usually results in a financial loss to an investor, clearly falling short of the “best interest” and “prudent investor” standards. And yet, in too many cases, there is no evidence in the court’s decision that they even considered this issue, as they simply reference the fact that the plan’s fees fell with the “acceptable range.”

Another issue that is rarely mentioned by the courts is the “closet index” mutual fund issue. This is a genuine issue that bears directly on the issue of fundamental fairness to investors. The issue has become even more significant recently, as more actively managed mutual funds have shown a tendency to closely track the performance of comparable indices and/or index funds to avoid large variances in returns and the possible loss of clients. Selecting funds with comparable performance records, but fees 300-400 percent higher than a comparable index fund, is obviously not something that a prudent investor would do and is not “acceptable.”

The key for the courts, plan sponsors and other investment fiduciaries is to better understand the various forms of returns frequently mentioned in the investment industry in order to ensure that they are comparing “apples to apples” and properly evaluating the value of services being provided to plans and plan participants. The most common forms of returns that should be considered by fiduciaries are

  • Nominal returns – these are the so-called absolute returns, with out any adjustment for factors such as loads and risk. These are the return numbers that mutual fund companies usually reference in their ads.
  • Load-adjusted returns – these are the returns for a fund after deducting the front-end load charged by a fund. Front-end loads result in lower end returns since an amount equal to the load is immediately deducted from an investor’s initial investment and any additional contributions to their account.
  • Risk-adjusted returns – these are the returns for a fund after factoring in the level of risk the fund assumed in producing its returns. Since there is no true “risk” factor, most people compare a fund’s standard deviation over the time in question to the standard deviation of a comparable benchmark over the same time period. Actively managed funds that assume less risk, i.e., lower standard deviation, than a comparable index fund see an increase in their risk-adjusted return, and vice versa.

Fiduciary Duties and Cost Efficiency
Both the courts and the Restatement (Third) Trusts emphasize a fiduciary’s duty to be cost conscious.(6) As the Tibble Court recently stated, “cost-conscious management is fundamental to prudence in the investment function.”(7)

One form of cost efficiency analysis that is gaining popularity is a simple cost benefit analysis combining Charles D. Ellis’ studies on incremental cost/return investment analysis with Ross Miller’s metric, the Active Expense Ratio (AER). The AER addresses the “closet index” issue by calculating the effective annual expense ratio of an actively managed mutual fund. The AER is then compared to a fund’s incremental return to determine if the fund is prudent in terms of cost efficiency.

My proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR), also calculates the cost efficiency of an actively managed mutual fund. Based on the studies of investment icons Charles D. Ellis and Burton Malkiel, the AMVR is a variation of the well-known simple cost/benefit analysis formula, with the AMVR using a fund’s incremental cost and incremental return as the numerator and denominator, respectively. For more information about the AMVR, click here.

Brave New World
With the DOL’s new fiduciary rule, it will be more important than ever that plan sponsors and other plan fiduciaries be able to understand how to calculate and interpret the various types of returns commonly discussed in the investment and pension industries. As pointed out, blind reliance on service providers and other third parties has never been acceptable.

Such blind acceptance is even more unacceptable now since plan fiduciaries will need to be able to monitor and evaluate the quality of advice and other services provided by third parties, or potentially face joint unlimited personal liability for their failure to do so. Courts must look beyond a fund’s absolute returns and factor in the value, if any, of the services and performance that a plan and plan participants are receiving in return for such fees. If a fund is not providing any measurable positive benefit to a plan and its participants, then such a fee is not “acceptable,” regardless of what other courts may have decided.

Bottom line, courts, plan sponsors and investment fiduciaries in general must be able to differentiate between nominal returns, load-adjusted, and risk-adjusted returns in order to (1) know when each is appropriate, and (2) to be able to properly determine whether a fund is providing commensurate value for higher fees in order to ensure that they are properly comparing “apples to apples” in order to act in the “best interests” of a plan and its participants.

1. Fink v. National Savings and Trust Co., 772 F.d 951, 957 (D.C.C. 1985)
2. Gregg v. Transport. Workers of America, Int’l, 343 F.3d 833, 841 (6th Cir 2003)
3. Liss v. Smith, 991 F. Supp. 278, 299 (S.D.N.Y.)
4. TIAA-CREF, “Assessing the Reasonableness of 403(b) Pension Plan Fees,” available online at https://www.tiaa.org/public/pdf/performance/ReasonablenessoffeesWP_ Final.pdf
5. Restatement (Third) Trusts, §90, cmt h(2) and cmt m
6. Tibble v. Edison Internat’l, 843 F.3d 1187, 1197 (9th Cir 2016); Restatement (Third) Trusts, §§80 cmt a, and 90, cmt h(2) and cmt m
7. Tibble, at 1

© 2017 The Watkins Law Firm. All rights reserved.

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



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