CommonSense InvestSense ERISA 401(k)/403(b) Litigation

The very essence of leadership is that you have to have a vision. You can’t blow an uncertain trumpet. – Father Theodore Hesburgh, University of Notre Dame

Over twenty years ago, I registered the domain name “investsense.com.” Since then, I have advocated what my concept of the term means and the potential benefits that can be derived by practicing investsense.

InvestSense – the art and science of combining sound, proven investment techniques and strategies with simple, common sense,

My vision is equally simple:

• Plaintiff ERISA attorneys who incorporate CommonSense InvestSense principles into their practices should never lose a 401(k)/403(b) fiduciary breach case.

• 401(k) and 403(b) plan sponsors who properly incorporate CommonSense InvestSense principles into the plan’s investment selection process should never lose an action alleging a breach of their fiduciary duties.

Now, I cannot guarantee those outcomes because, as we have seen, the courts have made some “interesting” decisions based on arguments that seem contrary to both ERISA’s stated purpose and the common law of trusts, from which fiduciary law is largely derived. As I write this post, SCOTUS is considering whether to rectify some questionable rulings involving a plan sponsor’s burden of proof in 401(k)/403(b) litigation

The basic rule of pleading is that the plaintiff is only required to provide the defendant with sufficient information to put the defendant “on notice” of what the plaintiff’s general allegations, or “notice pleading.” The reason for this rule is that the specific information involved in the alleged wrongdoing is, in most cases, exclusively within the possession of the defendant in the early stages of litigation and until the plaintiff has had the opportunity to conduct discovery. Therefore, it would be, and is, inherently inequitable to require greater specificity in the plaintiff’s initial pleadings.

Yet, some courts have done just that, dismissing 401(k) and 403(b) fiduciary breach actions based not on the merits of the case, but rather on concepts such as “comparing apples and oranges” and “menu of options.” The arguments against such questionable standards is that not only are they inconsistent with ERISA’s provisions, but they also ignore ERISA’s stated purpose, the protection of pension plan participants. Too often, recent ERISA court decisions have seemed to go out of their way to protect plans at the expense of the plan’s participans.

In two separate cases, Putnam Investments, LLC v. Brotherston and now Hughes v. Northwestern University, the Solicitor General has submitted an amicus brief to SCOTUS arguing that the burden of proof on the issue of causation, i.e., whether the plan sponsor was prudent in the selection of the plan’s investment options, should fall on the plan sponsor once the plan participants have provided sufficient notice pleading. The Solicitor Generals have pointed out that such a duty would be consistent with both the common law of trusts and rulings of other U. S. appellate courts.

SCOTUS has not indicated whether it will hear the Northwestern case. With the term of the current term almost over, it appears that the earliest the Court would consider the case will be the next term, which begins in October.

In the meantime, plan sponsors and plaintiff ERISA attorneys should consider the potential benefits of incorporating CommonSense InvestSense principles, as they would apply regardless of the outcome in the Northwestern case. The basic foundation for the InvestSense concept is the studies of investment icons Nobel laureate Dr. William D. Sharpe, Charles D. Ellis and Burton Malkiel.

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

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

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover.³

This emphasis on cost consciousness and the cost-efficiency of investments is consistent with the fiduciary principles set out in the Restatement (Third) of Trusts. The importance of costs and cost-efficiency is also a core concept in the SEC’s new Regulation Best Interest (Reg BI). In discussing Reg BI’s provisions regarding costs as a factor in recommending investments, former SEC Chairman Jay Clayton stated that

A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes utility.⁴

[A]n efficient investment strategy may depend on the investor’s utility from consumption, including…(4) the cost to the investor of implementing the strategy.⁵

One comment was particularly interesting with regard to its applicability to the concept of InvestSense.

[W]hen a broker-dealer recommends a more expensive security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that the higher cost is justified (and thus nevertheless in the retail customer’s best interest) based on other factors….⁶

So cost matter. John Bogle said it. Ellis, Sharpe and Malkiel said it. And now former SEC Chairman Clayton is on record as saying it. I cannot wait to hear how plan sponsors are going to argue that cost-inefficient investment options are justified/prudent. So how does that translate into 401(k)/403(b) litigation and the potential benefits to ERISA plaintiff attorneys and plan sponsors of incorporating the core principles of InvestSense into their worlds?

A couple of years ago I created a metric, the Active Management Value Ratio^TM (AMVR), that allows investors, fiduciaries and attorneys to simply and quickly determine the cost-efficiency, and thus prudence, of actively managed mutual funds. Additional information about the AMVR is available on this blog, or click here.

Again, if SCOTUS does rule that plan sponsors have the burden of proof on the issue of causation, then plan sponsors will face the same cost-efficiency issues addressed by Clayton, the need to show a reasonable basis for the selection of higher cost investment options for their plan. That may prove to be a formidable task, given that studied have consistently shown that the overwhelming majority of actively managed funds are cost-inefficient relative to comparable passive, or index funds.

• 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.⁷
• 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.⁸
• [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁹
• [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.¹⁰

These findings have resulted in recommendations that investment fiduciaries such as plan sponsors seriously consider selecting index funds instead of actively managed mutual funds. John Langbein, who served as the Reporter for the committee that wrote the Restatement (Thrid) of Trusts offered the following advice:

When market 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 accounts. 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.¹¹

And the First Circuit Court of Appeals took the unusual step of offering the following advice to those who might object to its Brotherston decision:

In so ruling, we stress that nothing in our opinion places on ERISA fiduciaries any burdens or risks not faced routinely by financial fiduciaries. While Putnam warns of putative ERISA plans forgone for fear of litigation risk, it points to no evidence that employers in, for example, the Fourth, Fifth, and Eighth Circuits, are less likely to adopt ERISA plans. 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.”¹²

For my part, I offer the following AMVR fiduciary analysis comparing a very common investment option in 401(k) and 403(b) plans, the Fidelity Contrafund Fund (FCNKX), to the Fidelity Large Cap Growth Index Fund (FSPGX). As the slide clearly shows, Contrafund is cost-inefficient, and thus imprudent, relative to Fidelity’s own large cap growth index fund.

This is not to slight Contrafund’s legendary manager, Will Danoff. Working against Contrafund is its high expense ratio (77 basis points) and high R-squared correlation number (97) relative to the large cap growth index fund. The disparity is even more alarming if the analysis is done using Ross Miller’s Active Expense Ratio, which factors a fund’s R-squared correlation number even more heavily.

Trust me, there are plenty of other examples documenting the cost-inefficiency of popular 401(k)/403(b) actively managed mutual funds. The fact is that “true” actively managed mutual funds will always have higher expense ratios (Ellis) and higher trading costs (Malkiel).

Advocates of actively managed funds often argue that active management can offset such higher costs with better performance. Theoretically, yes. However, remember the quotes from the earlier studies. History does not support that optimism.

Furthermore, Contrafund’s high R-squared correlation number (97), is reflective of a definite trend of more than a decade of U.S. domestic equity funds having correlation numbers of 90 and above, many higher than 95, relative to comparable index funds. Bottom line-odds of a fiduciary breach being found are extremely high when actively managed funds are compared to comparable index funds.

Going Forward
At the beginning of this post, I set out two of my visions about CommonSense InvestSense

ERISA plaintiff attorneys who incorporate CommonSense InvestSense principles into their practice should never lose a 401(k)/403(b) fiduciary breach action.

410(k) and 403(b) plan sponsors who properly incorporate CommonSense InvestSense principles into the plan’s investment selection process should never lose an action alleging a breach of their fiduciary duties

As I have explained the importance of the Northwestern case and the potential ramifications of a SCOTUS decision to plan sponsors, I usually get a question as to why there are no potential adverse implications from the case for plan advisers since, in most cases, the plan sponsors were simply following the plan adviser’s recommendations and advice. There

There are definitely potential adverse implications for plan advisers as a result of a SCOTUS decision in the Northwestern case. However, those implications will most likely be determined by plan sponsors reaction to the Court’s decision rather than as a result of the decision itself.

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 athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
3. Burton G. Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
4. “Regulation Best Interest: The Broker-Dealer Standard of Conduct,” Release No. 34-86031; File No. S7-07-18, https://www.sec.gov/rules/final/2019/34-86031.pdf, 378
5. Ibid., 378
6. Ibid., 279
7. . Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
8.. 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.
9. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
10. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
11. Brotherston v. Putnam Investments, LLC,, 907 F.3d 17, 39 (1st Cir. 2018)
12. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498.

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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.implications