Recently, there have been a number of court decisions dismissing 401(k)/403(b) ERISA breach of fiduciary actions. I have to admit, I am still puzzled by some of the decisions, as the rationales cited by some of the courts seems to be inconsistent with long-standing ERISA precedent.
Whenever I read an ERISA decision, the first thing I look for are the “usual suspects.” As soon as I see these cases cited by a lower court, I immediately question the ability of the lower court’s decision to withstand rigorous appellate review. Some people have said that my “usual suspect” checklist helps them evaluate ERISA decisions. With that in mind, here are some of my most common “usual suspects.”
Vanguard Mutual Fund Are Unacceptable Benchmarks
In Shaw v. Delta Air Lines, Inc., the Supreme Court stated that
ERISA is a comprehensive statute designed to promote the interests of employees and their beneficiaries in employee benefit plans.1
In one recent decision, the court dismissed an ERISA action based the disallowance of the plaintiff’s use of Vanguard for benchmarking purposes. The court cited the fact that Vanguard’s business relies on an “at-cost” business model, while most actively managed mutual funds use a for-profit model, thus putting actively managed funds at a distinct advantage.
However, if the “best interests” of a plan participant are truly the focus under ERISA, then it seems that the fund that provides the best performance for a plan participant, the fund that improves their “retirement readiness,” should be the court’s primary concern rather than the funds’ business model or promoting the interests of actively managed plans.
In Hirshberg & Norris v. SEC, the court dealt with an analogous situation where the appellee essentially argued that the federal securities laws and regulations were enacted to protect broker dealers rather than the investing public. The court quickly rejected the appellant’s argument, stating that
To accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protections of the broker-dealer rather than the protection of the public….On the contrary, it has long been recognized by the federal courts that the investing and usually naïve public needs special protection in this specialized field. We believe that the Securities Act and the Securities Exchange Act were designed to prevent, among other things, just such practices and business methods as have been shown to have been indulged in by the petitioner in this case.2
I Meant Well/I Had Good Intentions
In another recent ERISA action, one of the court’s stated grounds for dismissing the plan participants’ action was the alleged subjective feelings and beliefs of the plan and the members of the plan’s investment committee. However, as the courts have consistently stated, subjective opinions and beliefs are totally irrelevant in deciding ERISA cases involving alleged breaches of one’s fiduciary duties.
Contrary to the appellee’s contentions, this is not a search for subjective good faith – a pure heart and an empty head are not enough. The statutory reference to good faith in [ERISA] Section 3(18) must be read in light of the overriding duties of Section 404.3
As I often explain to people, there are no mulligans in ERISA. When it comes to ERISA fiduciary law, in the words of that great philosopher, Yoda, “do or don’t do; there is no try.”
And yet, we are seeing cases where a court is seemingly attempting to rationalizing an obvious violation of ERISA on some version of the “pure heart, empty head” defense.
Hundreds of Investment Options = No Fiduciary Breach
A common rationale given by the courts for dismissing ERISA actions is the number of investment options offered by a plan. The court’s reasoning seems to be that the more investment options offered by a plan, the less likely they can be deemed to have breached their fiduciary duty of prudence. This is commonly referred to as the ”menu of options” defense. Most courts attempt to justify this opinion based on the Hecker v. Deere & Co. decision. (Hecker I)4
What the courts relying on the “menu of options” defense seem to forget is that the Hecker I decision caused such an uproar that the Seventh Circuit quickly went back and issued a “clarification” of their decision in Hecker II.5 In Hecker II, the court made it clear that offering a large number of investment options within a 401(k)/403(b) defined contribution plan does not insulate the plan or the plan’s fiduciaries from liability for the imprudent selection of a plan’s investment options.
As the Sixth Circuit noted in properly nullifying the “menu of options” defense,
Such a rule would improperly shift the duty of prudence to monitor the menu of plan investments to plan participants. The Seventh Circuit opined that such a standard ‘would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives’…[T]he fact remains, ERISA charges fiduciaries like [plan sponsors and other plan fiduciaries] with ‘the highest duty known to law,’ which includes the duty to prudently select investment options and the duty to act in the best interests of the plans.
Much as one bad apple spoils the bunch, the fiduciary’s designation of a single imprudent investment offered as a part of an otherwise prudent menu of investment choices amounts to a breach of fiduciary duty, both the duty to act as a prudent person would in a similar situation with single-minded devotion to the plan participants and beneficiaries, as well as the duty to act for the exclusive purpose of providing benefits to plan participants and beneficiaries.6
Attorneys are not supposed to mislead the courts as to applicable legal precedent, for good reason. So given the Seventh Circuit’s “clarification” in Hecker II, one has to wonder why the a court would attempt to rely on Hecker I and the “menu of options” defense without even mentioning the decision in Hecker II, when various federal appellate courts, and even the Hecker court itself, have effectively nullified the defense. There are those that argue that Hecker II was a clarification, not a reversal. Some ERISA attorneys would respectfully beg to differ.7 If it walks like a duck and quacks like a duck….
Interestingly enough, plans sponsors actually increase their potential for breaching their fiduciary duties by offering more investment options within their plan. In defined benefit plans, the plan retains the risk of loss. In defined contribution plans, the plan sponsor selects the plan’s investment options, but the plan participant bears the risk of investment loss. Therefore,
Under ERISA, the prudence of investments or classes of investments offered by a plan must be judged individually….That is, a fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to plan participants. Here the relevant “portfolio” that must be prudent is each available Fund considered on its own, including the Company Fund, not the full menu of Plan funds.8
Therefore, the greater the number of investment options a plan sponsor offers within an ERISA defined contribution plan, the greater the plan sponsor’s potential liability.
The Reasonableness of Mutual Funds’ Expense Ratios Is a Question of Law
Several courts have recently dismissed ERISA actions on the grounds that the expense ratios of the funds involved were appropriate as a matter of law. The “question of law” or “question of fact” is very important, as questions of fact are generally the exclusive province of a jury. Therefore, judges are generally not allowed to dismiss an action if there are genuine questions of fact remaining in an action.
One court addressed the issue by properly pointing out that neither fund fees nor fund performance can be evaluated “in a vacuum.” Then the court went and did just that. To suggest that a mutual fund’s expense ratio can be deemed acceptable, much less a matter of law, based on an expense ratio alone is puzzling.
In Tibble v. Edison Int’l,9 SCOTUS acknowledged that the courts often turn to the Restatement (Third) of Trusts (Restatement) to resolve fiduciary questions, especially those involving ERISA. Three comments in Section 90 of the Restatement are especially relevant with regard to the issues of the appropriateness of a fund’s expense ratio:
- A fiduciary has a duty to be cost-conscious. (cmt. a)
- A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.(cmt. f)
- Actively managed mutual funds that are not cost-efficient are imprudent. (cmt. h(2))10
Comment h(2) would seem to suggest that in evaluating an actively managed fund’s fees, it must be determined whether the fund provides an investor with a commensurate level of return for the extra costs and risks associated with the fund. None of the decisions involving the idea of expense ratios acceptable as a matter of law mentioned whether the 401(k)/403(b) plans considered the cost-efficiency requirement established under the Restatement’s Section 90, comment h(2) requirement.
Restatement Section 90, comment h(2) actually asks whether an actively managed fund is able to cover the additional costs and risk associated with actively managed mutual funds. Research has consistently found that the majority of actively managed mutual funds do not cover their costs.
“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.” 11
“[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.12
[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.13
Pension plans, investment fiduciaries and mutual funds do not want to discuss cost-efficiency. They know that the overwhelming majority of actively managed mutual funds are not cost-efficient in their current form and likely never will be given their very nature.
As of February 3, 2019, the Morningstar Investment Research Center was reporting that the average expense ratio for domestic large cap growth funds was 1.10%, with an average turnover ratio of 61% and a 5-year annual return of 7.75. Meanwhile, the average expense ratio for an acceptable large cap growth benchmark, the Admiral shares of the Vanguard Growth Index Fund (VIGAX), was 0.05%, with an average turnover ratio of 8% and a 5-year annualized return of 9.00%.
Using John Bogle’s “all-in” expenses concept14, the actively managed fund would have to cover approximately 178 basis points just to break even, assuming the actively managed fund managed to even outperform the index fund. In this case, the actively managed fund failed to do so, underperforming the index fund by 1.25%. Given the fact that many funds, especially domestic large cap fund, have increasingly shown a high R-squared, or correlation of returns, number, that hurdle could be significantly more difficult.
The higher costs, both expense ratios and trading costs, make it unlikely that an actively managed fund can meet the standard establish by comment h(2) of the Restatement’s Section 90. I created a simple metric, the Active Management Value Ratio™ 3.0 (AMVR), to help investors, plan sponsors and investment fiduciaries analyze the cost-efficiency of actively managed mutual funds. For more information about the AMVR and the calculation process, click here.
Investment icon Charles D. Ellis has also pointed that a mutual fund’s stated expense is highly misleading. Since an investment manager or mutual fund plays no part in creating the initial assets brought into an account, Ellis properly suggests that the effective expense ratio for an asset manager of a mutual fund should be expressed in terms of the fund’s costs relative to its performance. As an example, Ellis cites a fund with a stated expense ratio of 1% of assets under management. If the fund produces an actual return of 8%, then the effective expense ratio would be more properly seen as 12.5% (1/7).15
401k and 403b plans that continue to select actively managed funds for their plans face an admittedly difficult challenge. However, the courts have an obligation to enforce the applicable law, including appropriate precedents. In too many cases, an argument can be made that the courts are not doing that.
In perhaps a message to other plan fiduciaries and other courts, in their recent Putnam decision, the First Circuit Court of Appeals stated that
More importantly, the 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.
Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.’16
John Langbein was the reporter for the committee that wrote the current Restatement (Third) of Trusts. Over forty years ago he co-wrote an article predicting the potential impact of the Restatement.
When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify. 17
Based upon its opinion in the Putnam decision, the First Circuit Court of Appeals appears to believe that that day is here.
Copyright © 2019 The Watkins Law Firm. All rights reserved.
This article is for informational purposes only. It is neither designed nor intended to provide legal, investment, or other professional advice as 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.
- Shaw v. Delta Airlines, Inc., 463 U.S. 85, 90, 103 S. Ct. 2890, 77 L. Ed. 2d 490 (1983).
- Hirshberg & Norris v. SEC, 177 F.2d 228, 233 (1949)
- Donovan v. Bierwirth, 716 F.2d 1455, 1467 (5th Cir. 1983).
- Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009) (Hecker I)
- Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009) (Hecker II)
- Pfeil v. State Street Bank & Trust Company, 671 F.3d 585, 587, 597-98 (6th Cir. 2012).
- Fred Reish, “Hecker v. Deere Revisited,” available online at https://www.drinkerbiddle.com/insights/publications/2009/09/hecker-vs-deere-revisited.
- DiFelice v. U.S. Airways, 497 F.3d 410, 423, fn. 8 (4th Cir.)
- Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
- Restatement (Third) Trusts, Section 90, cmt. h(2)
- Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www..ft.con/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e
- Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
- Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
- Available online at http://www.johnbogle.com
- Charles D. Ellis,“Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (McGraw-Hill Education: New York, NY), 2018, 163-164.
- Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018)
- John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law (1976). (Faculty Scholarship Series: Paper 498) available online