While no one is certain at this point what the eventual DOL fiduciary rule will look like, or whether there will even be a DOL fiduciary rule, fiduciary law will continue to exist and establish the liability standards for investment fiduciaries. When it comes to interpreting fiduciary standards under ERISA, the courts have consistently stated that they look to Restatement (Third) Trusts (Restatement) for guidance.
A fiduciary’s duties of loyalty and prudence are well-known. The duty loyalty requires a fiduciary to always act in the best interests of a client, “solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries.”1 The duty of prudence requires a fiduciary to act
with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.2
What many plan sponsors and other investment fiduciaries are not aware of is that implicit in the fiduciary duty of prudence is a duty to be cost-conscious.3 The Restatement provides guidance to fiduciaries in meeting their duty to be cost-conscious, pointing out that
Because the differences in the totality of the costs…can be significant, it is important for the [fiduciary] to make careful overall cost comparisons, particularly among similar products of a specific type being considered for a [plan’s] portfolio.4
Many 401(k) select actively managed mutual funds as investment options within their plan. In making such a decision, the Restatement warns plan sponsors that
a decision to proceed with such a program involves judgments by [a fiduciary] that: a) gains from the course of action can reasonably be expected to compensate for its additional costs and risks,…”5
Low Hanging Litigation Fruit Under the DOL’s Fiduciary Rule and BICE
With that framework in mind, two investments that would appear to be prime targets for plaintiffs’ ERISA attorneys are variable annuities and actively managed mutual funds. Both of these products have legitimate cost efficiency issues, thereby drawing the attention of the plaintiffs’ bar.
The cost issues associated with variable annuities have been one of the main reasons that variable annuities have consistently been a leader in customer complaints to regulatory bodies. Fiduciary law is based largely on a combination of trust, agency and equity law. A basic tenet of equity law is that “equity abhors a windfall.” Common sense alone tells you that a windfall achieved at the cost of a plan participant is neither in their best interests nor for their benefit.
And yet, most variable annuities do just that, as their fee structures ensure an unfair and onerous windfall for the variable annuity issuer. In a landmark study of the fees associated with variable annuities, Moshe Milevsky estimated that the inherent value of the annual M&E fee charged by variable annuities was only between 5-10 basis points (a basis point is 1/100 of 1 percent), depending on factors such as age and gender.6 The fact that insurance companies were charging a median annual M&E fee of 115 basis led Milevsky to conclude that the M&E fee being charged was not actually related to the actual costs of providing such a benefit to variable annuity owners, and therefore,
if the M&E fee was only meant to cover true risk — the typical VA policyholder was being grossly overcharged for this so-called protection and peace of mind.7
The passage of time has not changed Milevsky’s opinion of his original findings demonstrating the windfall variable annuity issuers receive from the M&E fee, as he has recently stated that
Indeed, I still stand behind those results. Our basic position was that for many investors, a similar financial economic outcome could be achieved at a lower cost.8
Another cost efficiency issue of a variable annuity’s M&E fee is the fact that the fee is based on an absurd process known as “inverse pricing.” Inverse pricing refers to the fact that the annual M&E fee is based on the accumulated value of the variable annuity. The M&E fee provides the death benefit for a variable annuity owner, and the death benefit guarantees that the owner will never receive less than his/her actual contributions to the variable annuity. So, variable annuity owners whose variable annuities have experienced significant appreciation, and thus do not need the death benefit, are paying a higher fee for a benefit that they cannot use. Another windfall for the insurance company/variable annuity issuer.
The overall fees associated with variable annuities present cost efficiency issues. Variable annuities basically charge three types of fees: (1) the M&E, essentially the fee for the death benefit; (2) administrative fees; and (3) sub-account fees for the variable annuity’s investment options. The cumulative amount for such fees is typically 3 percent or more.
Most variable annuities now offer various types of “living benefit” riders that provide minimum guarantees with regard to accumulation rates and income distributions. The fee for such additional riders is usually in the range of 1 percent for each rider selected. Given the fact that each additional 1 percent in investment fees reduces an investor’s end return by approximately 17 percent over a period of twenty years, the cost efficiency issues inherent with variable annuities is obvious.
Bottom line, in their present form, most variable annuities will never pass the fiduciary standards of loyalty and prudence. Many in the financial services industry believe that some insurance companies have decided to sell their variable annuity businesses to other companies. Unless and until variable annuity issuers create and implement strategies that are compliant with the fiduciary duty to be cost efficient, variable annuities will continue to be a prime target for ERISA’s plaintiff’s bar.
Actively Managed Mutual Funds
Anyone involved in the financial services industry is well aware of the ongoing debate concerning actively managed mutual funds and passively managed, or index, funds. The Restatement actually establishes a standard for assessing the prudence of recommending and selecting actively managed funds.
a decision to proceed with such a program involves judgments by [a fiduciary] that: a) gains from the course of action can reasonably be expected to compensate for its additional costs and risks,…”9 (emphasis added)
|Category||5 years||10 Years||15 Years|
|All Domestic Funds||85.82||82.87||82.23|
|All MidCap Funds||89.95||96.03||95.40|
|All SmallCap Funds||96.57||95.64||93.21|
The cost efficiency issues inherent in actively managed mutual funds is raised to another level given studies that show that the majority of actively managers fail to produce returns that even cover their fund’s costs.10
The reported inability of so many actively managed funds to even cover their costs led me to create a metric, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR builds upon the studies of investment icons Charles D. Ellis, Burton Malkiel and Mark Carhartto provide a simple cost/benefit metric that allows investors, plan sponsors and attorneys to quickly and easily evaluate the cost efficiency of an actively managed fund.
Ellis contributed the concept of evaluation based on a fund’s incremental costs and incremental return.11 Malkiel and Carhart contributed their findings that the two most reliable indicators of a fund’s future performance were its annual expense ratio and its turnover/trading costs.12
In my practice, I use the AMVR to evaluate the cost efficiency of actively managed in terms of four types of returns – nominal return, load-adjusted returns, risk-adjusted returns, and Active Expense Ratio-adjusted returns. Ross Miller’s Active Expense Ratio metric addresses the “closet indexing” issue by calculating an actively managed fund’s effective annual expense ratio based on a fund’s R-squared rating. For more information about the AMVR, click here.
My AMVR calculations support the findings that very few actively managed funds are able to produce returns that even cover their costs, much less outperform their respective benchmark. These findings should make any plan sponsor or other investment fiduciary think twice before recommending or selecting actively managed funds for their plan or clients. After all, does a prudent person invest in an investment whose past performance suggests that the investor will lose money? Does a prudent person invest in a more expensive investment when a comparable investment has a history of providing the same, or higher returns?
One common mistake I see plan sponsors make is evaluating actively managed funds using a fund’s nominal returns. In some cases, I think this error is due to the fact that fund’s typically advertise their nominal returns, even though they know the front-end sales loads their funds charge will significantly reduce the effective return their customers receive.
The financial services industry often downplays the importance of risk-adjusted returns, often by saying that “investors cannot eat risk-adjusted returns” And yet those same people and firms have no problem using Morningstar’s star ranking for their funds in their ads. Morningstar bases its star system rankings on a fund’s risk-adjusted returns.
“Closet indexing,” or index hugging, refers to a situation where an actively managed mutual fund closely tracks the performance of a relative index or index fund. Despite the fact that actively managed funds often ridicule index funds, the evidence clearly indicates that the percentage of actively managed mutual funds closely tracking comparable index funds continues to increase. Actively managed funds have apparently adopted an “if you can’t beat ’em, join ‘em” strategy in order to avoid significant variance in return that could cost them clients.
The Acceptable Range of Fee Myth
One recent development in ERISA excessive fees cases deserves special mention. Several recent court decisions have ruled in favor of 401(k) plans based on their position that the range of fees for the investment options with the plan fell with an “acceptable range” of fees based on previous court decision involving a similar range of fees.13
What is troubling with this recent trend is the fact that the financial services industry has long argues that the suitability/prudence of investments should not be based on the absolute level of the fees of an investment. And yet, that appears to be exactly what the courts are now doing, in direct opposition to the Restatement’s position.
Recent court decisions have cited the fact that ERISA does not require a plan fiduciary to select the cheapest investment option, which is true. However, ERISA also does not give plan fiduciaries carte blanche power to ignore the wants and needs of plan participants and pick more expensive actively managed funds that fail to provide plan participants with a commensurate return for the added costs and risk involved with actively managed funds.
Such an approach is clearly inconsistent with both the Restatement and the stated purpose of ERISA. As TIAA-CREF correctly pointed out,
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.14
Given the overwhelming percentage of active managed funds that fail to provide any positive incremental return to investors, or whose funds fail to cover their costs, thus frustrating their expressed purpose of ERISA, courts and other regulatory bodies should base their decisions on an overall evaluation of the cost efficiency of a plan’s investment options using appropriate cost and return numbers.
The DOL’s recently announced fiduciary standard continues to face strong opposition by the financial services industry. The exact terms of the eventual fiduciary standard, or even if the new rule will survive at all, remain to be seen. That being said, 401(k) will continue to be subject to litigation based on issues such as excessive fees and the selection of imprudent investment choices.
Fortunately, plan sponsors and other investment fiduciaries can look to the Restatement to provide valuable guidance on how to create and maintain a plan that is compliant with applicable fiduciary standards, thus reducing the potential for unwanted liability exposure. Plan advisers can also use the Restatement as a compliance blueprint to provide valuable advice to their clients.
© 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.
1. Tibble v. Edison, Int’l, 135 S. Ct 1823 (2015)
2. 29 U.S.C. §1104(1)(A)
3. 29 U.S.C. §1104(1)(B)
4. Restatement (Third) Trusts, §§ 88 cmt a, 90 cmt b
5. Restatement (Third) Trusts, §§ 90 cmt m
6. Restatement (Third) Trusts, §§ 88 cmt h(2)
7. Moshe Milevsky, “Confessions of a VA Critic,” Research Magazine, January 2007, 42-48
8. Milevsky, Ibid.
9. Restatement (Third) Trusts, §§ 88 cmt h(2)
10. Philipp Meyer-Braun, “Mutual Fund Performance Through a Five Factor Lens,” Dimensional Fund Advisors, August 2016
11. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing.”6th ed. (New York, NY: McGraw/Hill, 2018), 104.
12. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460; Mark M. Carhart, “On Persistence in Mutual Fund Performance,”The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
13. Acceptable range
14. TIAA-CREF, “Assessing the Reasonableness of 403(b) Pension Plan Fees,” available online https://www.tiaa.org/public/pdf/performance/ReasonablenessoffeesWP_Final.pdf