3Q 2023 AMVR “Cheat Sheets”: Fiduciary Law Benchmarks That Really Matter

The six funds shown are six of the leading non-index funds that are consistently offered in U.S. domestic defined contribution plans. My development of the Active Management Value Ratio (AMVR) metric was originally based on the work of Nobel laureate Dr. William F. Sharpe and investment expert Charles D. Ellis.

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

The current version of the AMVR, AMVR 3.0, was modified to incorporate the work of Professor Ross Miller. Miller’s Active Expense Ratio (AER) factors in the high correlation of returns often found between actively managed funds and comparable passively managed/index funds. The AER provides investors with the implicit expense ratio they are paying for an actively managed fund. The AER also helps expose actively managed funds that are arguably “closet index” funds. As Miller explained,

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.³

The 3Q 2023 5 and 10-year AMVR “cheat sheet” numbers provide an opportunity to discuss pending 401(k) litigation that may significantly impact the 401(k) management and fiduciary liability in general. The 5-year “cheat sheet” shows that two funds qualified for an AMVR score.

In order for an actively managed to be eligible for an AMVR score, it must first produce a positive incremental return relative to the passively managed benchmark. American Fund’s Washington Mutual Fund received a 5-year AMVR score of 2.94, while Vanguard’s PRIMECAP fund received a 5-year AMVR score of 2.88.

However, neither fund would qualify as being prudent under the Restatement (Third) of Trusts’ fiduciary prudence standards since their AMVR score is greater than 1.00. An AMVR greater than 1.0 indicates that the fund’s incremental costs exceed the fund’s incremental returns. InvestSense uses correlation-adjusted costs and risk-adjusted returns in calculating a fund’s AMVR score, as they provide a more accurate representation of a fund’s cost/benefit to an investor.

The 10-year “cheat sheet” shows that three funds qualified for an AMVR score. American Fund’s Washington Mutual Fund received an AMVR score of 10.36, Vanguard’s PRIMECAP fund received an AMVR score of 1.01, and Fidelity Contrafund K shares received an AMVR score of 1.78.
However, none of the funds would qualify as being prudent under the Restatement (Third) of Trusts’ fiduciary prudence standards since their AMVR score is greater than 1.00, although a strong argument can be made for Vanguard PRIMECAP.

One often overlooked benefit of a fund’s AMVR score is that it provides an easy way to determine a fund’s cost premium. In the case of the 10-year Contrafund K shares analysis, the active fund’s incremental cost was 280 basis points (2.80), while the fund’s incremental return was 157 basis points (1.57).

The financial services typically uses basis points in making comparisons. A basis point is equal to 1/100th of one percent. Contrafund’s AMVR indicates that the fund’s cost premium of 123 basis points was equal to 78 percent cost premium (AMVR of 1.78 minus 1.00, multiplied by 100).

So how does this all tie into the pending 401(k) litigation cases? The Tenth Circuit Court of Appeals recently issued its much anticipated decision in Matney v. Briggs Gold of North America⁴. As I summarized in my earlier post, the Tenth Circuit upheld the district court’s dismissal of the plan participants’ 401(k) action claiming that the plan sponsor breached its fiduciary duties by (1) including imprudent investment options within the plan, and (2) imposing unnecessarily high fees on the participants. The Tenth Circuit basically relied on the usual “lack of meaningful benchmarks” and an interpretation of revenue sharing that had previously been rejected by other federal circuit courts of appeal.

The good news is that now the plan participants will, hopefully, apply to SCOTUS for certiorari so that the Court can establish uniform rules on both (1) the propriety of index funds as comparators in 401(k) and 403(b) litigation, and (2) the party who has the burden of proof on the causation of loss issue in such litigation. The Solicitor General submitted an amicus brief in the Brotherston case citing the common law as placing such burden of proof on a plan sponsor once the plan participants established a fiduciary breach and a resulting loss. The Department of Labor (DOL) recently submitted an amicus brief in the current Home Depot⁵ 401(k) litigation, essentially adopting the Solicitor General’s position.

Various courts have relied on the “lack of meaningful benchmarks” theory in dismissing 401(k) litigation cases. The Tenth Circuit discussed several theories of determining whether a proposed benchmark was actually comparable to the investment option chosen by a plan, including the familiar active/passive argument. The Court also discussed the comparison of expense ratios method, including an interesting argument based on the idea that any revenue sharing generated by funds in a plan must be applied on a 1:1 basis to reduce those funds’ expense ratio on a 1:1 basis. I addressed these issues in my last post.

What I want to discuss in this post is the concept of “meaningful benchmarks” aka comparators in connection with the AMVR. The Tenth Circuit suggested that to be a meaningful comparator, plan participants must go beyond performance and factor in questionable collateral issues such as a fund’s management strategies and goals. My position is, and always will be, that such collateral issues are meaningless to plan participants and in 401(k) and 403(b) litigation. A slide I often use in my classes expresses both my position and what investors consistently tell me.

The investment industry has always argued against using risk-adjusted returns in comparing investment options, stating that you “cannot eat risk-adjusted returns.” The same argument can be made against any requirement that a fund’s strategies and goals must be factored into any fiduciary prudence assessment in connection with ERISA-related litigation. If we recognize the stated purpose of ERISA is to protect employees, then attention in any 401(k) or 403(b) litigation should be solely on a fund’s cost-efficiency, more specifically the benefit that a fund provides to a plan participant relative to the costs/fees incurred.

In the Tibble decision⁶, SCOTUS recognized the value of the Restatement of Trusts (Restatement) in resolving fiduciary questions. SCOTUS recognized that the Restatement essentially restates the common law of trusts, a standard often used by the courts. The two dominant themes running throughout the Restatement are the dual fiduciary duties of cost-consciousness and diversification within investment portfolios to reduce investment risk.

In my fiduciary risk management consulting practice, I rely heavily on five core principles from the Restatement to reduce fiduciary risk. Three of the five principles are cost-consciousness/cost-efficiency principles:

Comment h(2)’s commensurate standard is a principle that I feel very few fiduciaries do, or can, meet if they include actively managed mutual funds in their plan. Actively managed funds start from behind in comparison to comparable passive/index funds due to the extra and higher expenses they incur from management fees and trading fees. As a result, a case can be made that ERISA plaintiff attorneys could effectively use the Restatement’s commensurate return and SCOTUS’ approval of the Restatement effectively in 401(k) litigation

Advocates of active management often claim that active management provides an opportunity to overcome such cost issues. However, the evidence overwhelmingly indicates that very few do so, with most actively managed funds being able to even cover their extra costs.

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

Another factor to consider in such poor performance numbers has to do with the fact that actively managed funds typically show a high correlation of returns to comaparable index funds, with many showing a r-squared number of 90 and above. Such a high correlation of returns could suggest that the active fund involved is actually a “closet index” fund, misleading investors by charging a significantly higher fee than a comparable index fund based on the alleged benefits of the fund’s active management, while actually deliberately tracking, or mirroring, a comparable market index or index fund. Such misrepresentations are arguably fraud and violations of various federal securities laws.

The Restatement and the common law of trusts seemingly resolve both the issues involved in the Matney cases in favor of beneficiaries such as the plan participants. While we wait to see if the plan participants file to seek certiorari from SCOTUS, I have previously suggested that both plan sponsors and ERISA plaintiff attorneys need to act proactively and change the paradigm to use the Active Management Value Ratio metric to analyze the fiduciary prudence of a plan’s investment options.

The AMVR “cheat sheets” consistently document the potential liability issues that plan sponsors have created fo themselves. While many plan sponsors have indicated to me that they prefer to just ignore the situation and deal with it if and when a legal action is filed, I try to explain to them that the law does not recognize “willful ignorance” as a defense.

Businesses around the world utilize cost/benefit analysis into their decision making process. I believe that plan sponsors should as well. The familiar adage that a picture is worth a thousand words should hold true in 401(k) litigation, as it is hard to believe that any court would not understand that nay investment whose incremental costs exceed its incremental benefits is not, and never will be prudent under fiduciary law, regardless of the fund’s stated strategies and goals.

When I meet a prospective client, I always show them three AMVR slides representing actual investments in their plans. In most cases, they look at the slides and realize the liability issues they face. In the sample AMVR slide shown, the estimated damages in connection with the fund would be estimated at between $2.06 and $6.57 a share, compounded annually. Then repeat the analysis for every investment option within the plan.That explains why settlements are usually reported in terms of millions of dollars.

One of my mantras to my fiduciary clients is “commensurate returns and common sense” are a strong combination in fiduciary prudence cases. Restatement Section 90, comment h(2) discusses commensurate return in terms of the extra costs and risk plan participants be asked to incur in a plan’s investment options. That explains why InvestSense uses risk-adjusted returns and correlation-adjusted costs in calculating AMVR scores and fiduciary prudence. Common sense should indicate that cost-inefficient investments are never prudent.

If SCOTUS does hear the Matney case and rule that plan sponsors bear the burden of proving that they did not cause any losses suffered by plan participants, this might well be the type of evidence that plan sponsors will have to counter in order to win the case. In most cases, I do not believe that plan sponsors will be able to overcome the power of “humble arithmetic” and the simplicity, yet persuasiveness, of the AMVR evidence.

Going Forward
I believe that SCOTUS will use either the Matney case or the Home Depot case to resolve the inequitable division of the federal courts on the issue of which party in 401(k) litigation has the burden of proof on the issue of causation of loss. I also believe the Court will cite the Restatement to establish that mutual funds cannot be summarily be rejected as legally viable comparators in ERISA litigation, at least for the purposes of prematurely dismissing meritorious cases.

Citing the Sacerdote¹⁰ decision, the DOL made an interesting comment in its recent amicus brief in the Home Depot 401(k) action:

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.¹¹

I believe that once SCOTUS rules in the Matney and/or Home Depot cases, courts, attorneys, and plan sponsors will soon recognize the AMVR as a valuable fiduciary risk management analytical tool towards that can establish both the requisite fiduciary breach and resulting loss, effectively establishing that “no prudent fiduciary” would have chosen a cost-inefficient actively managed mutual fund.

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. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49.
4. Matney v, Barrick Gold of North America, No. 22-4045, September 6, 2023 (10th Circuit Court of Appeals (Matney 10th Circuit).
5. Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022)
6. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
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.
9. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
10. Sacerdote v. New York University, 9 F.4th 95 (2d Cir. 2021).
11. Department of Labor amicus brief in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022) (Amicus Brief), 26. https://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf

Copyright InvestSense, LLC 2023. 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.

Making ERISA Meaningful: Common Sense, “Humble Arithmetic,” SCOTUS, and the Matney Case

The Tenth Circuit Court of Appeals finally issued its much-anticipated decision in Matney v. Briggs Gold of North America¹ (Matney). As expected, the Court upheld the district court’s dismissal of the case. The good news is that the Tenth Circuit’s publication of the decision allows the plan participants to apply for certiorari so that SCOTUS can hear an appeal of the Tenth Circuit’s decision

I believe that SCOTUS will grant certiorari and hear the casel if the participants apply for cert given the importance of ERISA in people’s lives and the fact that a split currently exists within the federal court on several critical aspects of ERISA. I also believe that the Court will grant cert in Matney in order to resolve two important questions that were first presented to the Court in the Brotherston case.²

The Court denied certiorari in Brotherston based upon the advice of the Solicitor General of the United States due the fact that the case was still ongoing at that time. While the Solicitor General recommended that SCOTUS not grant certiorari, the Solicitor General stated that the First Circuit Court of Appeals had correctly decided both questions involved and then took the time to provide an excellent analysis of the issues.³

I maintain that Matney is essentially a revisiting of the Brotherston case, as the two key issues in Matney and Brotherston are identical. For that reason, I am going to address the Tenth Circuit’s decision more in terms of the Solicitor General’s excellent amicus brief in Brotherston rather than the Tenth’ Circuit’s opinion, as I believe it will provide a better perspective on SCOTUS’ ultimate decision in the case.

SCOTUS and the Tibble decision
The Tibble decision⁴ is often cited as setting forth the framework that SCOTUS and other courts use in deciding  ERISA cases.

An ERISA fiduciary must discharge his responsibility “with the care, skill, prudence, and diligence” that a prudent person “acting in a like capacity and familiar with such matters” would use. We have often noted that an ERISA fiduciary’s duty is “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. We are aware of no reason why the Ninth Circuit should not do so here.⁵

Substitute “Tenth Circuit” for “Ninth Circuit,” and I believe you could have the opening paragraph in a SCOTUS’ Matney decision.

As I mentioned earlier, both Matney and Brotherston involve the same two questions:

1. Are comparable market indices and index funds acceptable comparators when the prudence of actively managed mutual funds is an issue in 401(k)/403(b) litigation?

2. Which party bears the burden of proof on the issue of causation of loss in 401(k)/403(b) litigation?

Comparable Index Funds as Comparators 
The Solicitor General opined that the First Circuit Court of Appeals had correctly ruled in Brotherston that index funds are not, as a matter of law, improper comparators for determining whether an ERISA fiduciary breached their fiduciary duties and calculating the resulting damages.⁶

The Solicitor General noted that determining losses in an ERISA action follows the same procedure as in other fiduciary breach actions, comparing ‘the actual performance of the plan investments and the performance that otherwise would have taken place.” Citing Section 100, comment b(1) of the Restatement, the Solicitor General stated that appropriate comparators may include

[R]eturn rates of one or more suitable common trust funds, or suitable index mutual funds or market indexes (with such adjustments as may be (sic) appropriate.⁷

The Solicitor General noted that the Brotherston court cited other legal support for the use of index funds as valid comparators in calculating losses due a fiduciary breach.

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).⁸

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.’⁹

The Solicitor General noted that while the Restatement does not support the absolute rejection of comparable index funds as comparators for assessing fiduciary prudence and the establishing the requisite financial losses, the question as to the appropriateness of the funds chosen remained a question of fact for determination at trial.¹⁰

One aspect of establishing fiduciary imprudence and resulting losses in connection with actively managed mutual funds that courts and plan sponsors frequently overlook is the Restatement’s “commensurate return” position. The Restatement states that the use of actively managed funds and active management strategies is imprudent unless the fiduciary can objective predict that the investment in question can be expected to provide a commensurate return for the extra costs and risks assumed by beneficiaries/plan participants.

Studies have consistently shown that the overwhelming majority of actively managed funds fail to provide investors with a commensurate return, as most actively managed funds are cost-inefficient, failing to even cover their costs.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.¹¹ 

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.¹²

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.¹³

[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.¹⁴

The cost-inefficiency of most actively managed funds is even more pronounced if the correlation of returns between many actively managed and comparable passively managed funds is factored in. Ross Miller created a metric, the Active Expense Ratio, which measures the impact of correlation of returns in such situations. Miller’s research determined that once correlation of returns is considered, the effective costs investors pay is often 400-500 percent higher than the active fund’s stated expense ratio.¹⁵ This would obviously make it that much more difficult for plan sponsors to satisfy the Restatement’s “commensurate return” standard.

John Langbein, the reporter for the committee that drafted the Restatement (Second) of Trusts, had warned in 1976 that

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.¹⁶

Burden of Proof as to Causation of Loss  
As to the burden of proof on causation, the Solicitor General stated that

The ‘default rule’ in ordinary civil litigation when a statute is silent is that ‘plaintiffs bear the burden or persuasion regarding the essential aspects of their claims. But ‘the ordinary default rule, of course, admits of exceptions’¹⁷

The Solicitor General noted that one such exception applies under the law of trusts due to the high standards of conduct required of fiduciaries under the law. Citing both the Restatement and a highly respected treatise on trust law, the Solicitor General stated that

Under trust law, “when a beneficiary has succeeded in proving that the trustee has committed a breach of trust and that a related loss has occurred, the burden shift to the trustee to prove that the loss would have  occurred in the absence of the breach.’¹⁸

In further support of its position, the Solicitor General noted that the burden shifting on the issue of causation furthers the stated purposes of ERISA.

In trust law, burden shifting rests on the view that ‘as between innocent beneficiaries and a defaulting fiduciary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty. ERISA likewise seeks to ‘protect *** the interests of participants in employee benefit plans’ by imposing high standards of conduct on plan fiduciaries. Indeed, in some circumstances, ERISA reflects congressional intent to provide more protections than trust law. Applying trust law’s burden-shifting framework, which can serve to deter ERISA fiduciaries from engaging in wrongful conduct, thus advances ERISA’s protective purposes.¹⁹

The Solicitor General noted that SCOTUS has recognized that in some cases, shifting the burden on the issue of causation to plan sponsors furthers the goals and purposes of ERISA by allowing the plan sponsors to establish “facts peculiarly within the knowledge of” one party.²⁰

More importantly, we have many decades of experience with the allocation of the burden of proof called for routinely by trust law, with no evidence of any particular difficulties, unfairness, or costs in applying that rule in the few cases in which it actually makes a difference.²¹

The Department of Labor’s recent amicus brief in the current Hom Depot 401(k) litigation arguably resolved the burden of proof on causation debate by citing the Sacerdote decision in suggesting that

If a plaintiff succeeds in showing that ‘no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, abnd there is no burden left to ‘shift’ to the fiduciary defendant.²²

Winds of Further Change
Assuming that Matney applies for certiorari, I believe that SCOTUS will, and should, grant certiorari. The current division within the federal courts on the two questions involved in Matney have essentially made a mockery of ERISA and the fundamental protections guaranteed by the statute. ERISA’s guarantees and protections are far too important to employees to be handled so cavalierly.

One of the primary areas of contention has to do with procedural matters, specifically the relative requirements of the parties in connection with a motion to dismiss. Defendants in civil litigation typically file motions to dismiss in order to reduce costs and avoid the transparency of discovery.

The Second Circuit Court of Appeals Sacerdote v. New York University case²³ involved a number of the same issues involved in Matney, including revenue sharing. The court also provided an excellent analysis of the fiduciary standard and the resulting procedural issue in 401(k) litigation in general.

[The fiduciary prudence] standard focuses on a fiduciary’s conduct in arriving at an investment decision, not on its results, and asks whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment.²⁴

A claim for breach of the duty of prudence will “survive a motion to dismiss if the court, based on circumstantial factual allegations, may reasonably infer from what is alleged that the process was flawed” or “that an adequate investigation would have revealed to a reasonable fiduciary that the investment at issue was improvident.”²⁵

Plaintiffs allege that this information was included in fund prospectuses and would have been available to inquiring fiduciaries when the fiduciaries decided to offer the funds in the Plans. In sum, plaintiffs have alleged “that a superior alternative investment was readily apparent such that an adequate investigation” —simply reviewing the prospectus of the fund under consideration—”would have uncovered that alternative.” On review of a motion to dismiss, we must draw reasonable inferences from the complaint in plaintiffs’ favor.²⁶

While the plausibility standard requires that facts be pled “permit[ting] the court to infer more than the mere possibility of misconduct,” we do not require an ERISA plaintiff “to rule out every possible lawful explanation for the conduct he challenges.” To do so “would invert the principle that the complaint is construed most favorably to the nonmoving party” on a motion to dismiss.²⁷

Although plaintiffs bear the burden of proving a loss, the burden under ERISA shifts to the defendants to disprove any portion of potential damages by showing that the loss was not caused by the breach of fiduciary duty. This approach is aligned with the Supreme Court’s instruction to “look to the law of trusts” for guidance in ERISA cases. Trust law acknowledges the need in certain instances to shift the burden to the trustee, who commonly possesses superior access to information.²⁸

When I compare some of the recent dismissals of 401(k)/403(b) actions in the context of the clear standards set out in comments b(1) and f of Section 100 of the Restatement, my initial reaction is to recall Simon Sinek’s outstanding book, “Start With Why.”²⁹

The referenced Restatement sections appear to be necessary, objective and fair. In too many cases, the rash of dismissals appear to be deliberately and unnecessarily draconian and arguably designed to deny plan participants their ERISA’s protections by preventing transparency. some courts have noticed this trend.

The Sixth Circuit Court of Appeals is not necessarily known as an advocate for plan participants. And yet, Chief Judge Sutton addressed the inequitability of the noticeable dismissal trend in certain federal circuits, especially those requiring plan participants to plead and prove the mental processes of plan sponsors and plan investment committees without allowing plan participants to have the discovery needed to discover what processes were used in selecting and monitoring the plan’s investment options.

In rejecting the plan’s arguments on the prudence of selecting actively managed funds for a fund based on the purported benefits of revenue sharing they provided, Judge Sutton adopted a common sense, fundamental fairness argument.

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….’³⁰

This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth ‘investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares’ because ‘the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….’ Or maybe these considerations never entered the decision-making process. 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.³¹

Revenue Sharing
Revenue sharing is a much discussed issue in current 401(k)/403(b) litigation…and with good reason. In my opinion, Matney is a perfect example of the issues involved with revenue sharing and a perfect example of why SCOTUS needs establish a uniform standard on the issue of which party bears the burden of proof on the issue of causation.

Both the district court and the Tenth Circuit relied heavily on their accusation that the plan participants misrepresented the expenses ratios of investment options within the plan that provided revenue sharing. Both courts seemed to argue that the plan participants were obligated to reduce such funds’ expense ratios on a one-to-one basis by the stated revenue sharing amounts.

The attempt by both Matney courts to use revenue sharing to reduce a fund’s expense ratio is totally inconsistent with the Seventh Circuit’s acknowledgment that such attempts to offset expense ratios with revenue sharing payments on a one-to-one basis are improper. In another example of the “fundamental fairness” trend, the Seventh Circuit rejected the district court’s one-to-one offset argument, pointing out that

The problem is that the Form 5500 on which Albert relies does not require plans to disclose precisely where money from revenue sharing goes. Some revenue sharing proceeds go to the recordkeeper in the form of profits, and some go back to the investor, but there is not necessarily a one-to-one correlation such that revenue sharing always redounds to investors’ benefit. Albert’s ‘net investment expense to retirement plans theory’ assumes that there is such a correlation; if that assumption is wrong, then simply subtracting revenue sharing from the investment-management expense ratio does not equal the net fee that plan participants actually pay for investment management.³²

I have argued that in cases where revenue sharing is distributed among various cost contributors, far too often the resulting situation is one in which the plan participants are effectively victimized twice, once in simply reducing excessive bookkeeping costs that remain so even after credited with a portion of revenue sharing, then again in leaving plan participants burdened with over-priced, consistently underperforming, i.e., cost-inefficient, actively managed mutual funds. Such a situation is the anti-thesis of fiduciary prudence and the stated purpose of ERISA.

The Second Circuit addressed the fiduciary issues involved with revenue sharing in the Sacerdote case, insight that is equally applicable to the revenue sharing issues in Matney.

The fact that one document purports to memorialize a discussion about whether or not to offer retail shares does not establish the prudence of that discussion or its results as a matter of law.³³

We have no quarrel with the general concept of using retail shares to fund revenue sharing. But, there was no trial finding that the use here of all 63 retail shares to achieve that goal was not imprudent. Simply concluding that revenue sharing is appropriate does not speak to how the revenue sharing is implemented in a particular case. We do not know, for example, whether revenue sharing could prudently be achieved with fewer retail shares.³⁴

The Tenth Circuit’s presumptions and premature decisions with regard to the case’s revenue sharing issues may ultimately prove to be the Matney decision’s fatal flaw.

Going Forward
When the Tenth Circuit’s Matney decision was first announced, I received numerous email assuming that I would be upset since, allegedly, my previous Matney-related posts had been proven wrong.

The Matney decision should not have surprised anyone familiar with the Tenth Circuit’s precedent in this area. I just wanted an actual decision so that the plaintiff could begin the certiorari process. As for being wrongI have been wrong before and probably will be again. Then again, I have not heard the fat lady sing yet. If SCOTUS holds true to Tibble and its other ERISA fiduciary prudence decisions, she may never do so.

In the original Matney decision³⁵, the district court recognized that the selection process, not the ultimate performance of the product chosen by a plan, is the key issue in 401(k)/403(b) litigation. Two statements in the Tenth Circuit’s decision particular drew my attention:

(1) “circumstantial factual allegations ‘must give rise to a ‘reasonable inference’ that the defendant committed the alleged misconduct, thus ‘permit[ting] the court to infer more than the mere possibility of misconduct,”³⁶ and

(2) “[t]o show that ‘a prudent fiduciary in like circumstances’ would have selected a different fund based on the cost or performance of the selected fund, a plaintiff must provide a sound basis for comparison—a meaningful benchmark.”³⁷ (emphasis added)

Change “cost or performance” to “cost and performance” and I believe the letter and spirit of ERISA can be easily, and uniformly, accomplished. People who follow my posts are well aware of my position that the relative cost-efficiency of a fund, not its classification as active or passive, not a fund’s stated goals/strategies, should be the key factor in determining whether a plan sponsor or any other investment fiduciary has breached their fiduciary duties.

In the Hughes reconsideration decision³⁸, the Seventh Circuit noted that “cost-consciousness management is fundamental to prudence in the investment function. My Active Management Value Ratio (AMVR) metric provides a simple method of assessing the cost-efficiency of a fiduciary’s decisions. A sample of an AMVR analysis slide is shown below.

The slide clearly establishes a “reasonable inference” of a fiduciary breach, clearly showing the cost-inefficiency of the actively managed mutual fund relative to a comparable index fund, based on the actively managed fund’s incremental cost and return. The combination of the active fund’s relative underperformance (opportunity cost) and the fund’s incremental expense ratio cost could then be used to estimate both the loss and damages caused by the plan sponsor’s fiduciary breach.

The AMVR itself is essentially the basic cost/benefit equation, using incremental cost/return as the input data. The AMVR calculation itself is obtained by dividing an active fund’s incremental cost by its incremental return. An AMVR greater than “1.0” indicates that the actively managed fund is cost-efficient.

Plan sponsors, attorneys and courts can then see the extent of the cost-inefficiency, the “imprudence premium,” being reflected in the amount by which a fund’s AMVR score exceeds “1.0,” e.g., 1.50 indicates an imprudent premium of 50 basis points/50 percent. Estimated liability exposure and/or potential legal damages can then be calculated using the DOJ’s and GAO’s findings that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a 20-year period.³⁹

In the example shown, the fund’s negative incremental return automatically makes the fund an imprudent choice relative to the comparable index fund. While some may want to argue differences in strategies and goals, ERISA and the AMVR ignore the meaningless collateral arguments and focus on the ultimate benefit, if any, provided to the plan participants.

The example demonstrates that whatever the active fund’s strategies and goals may have been, they ultimately proved to be imprudent relative to the performance of the comparable benchmark, failing to provide an investor with a commensurate return for the additional costs and risks. Using the slide, the combined investment costs would have resulted in a loss of between $2.06 to $7.00 per share, compounded annually. Combining the AMVR slide and the findings of the DOL and GAO also shows that an investment in the active fund would have resulted in a plan participant suffering a minimum projected 34 percent loss in end-return over a 20-period relative to the index fund option.

Final Thoughts
If SCOTUS holds true to the position it announced in Tibble, the Restatement arguably provides a simple answer to the two questions posed in the Matney case.

1. Are comparable market indices and index funds acceptable comparators when the prudence of actively managed mutual funds is an issue in 401(k)/403(b) litigation?
 Answer: Section 100, cmt b(1) of the Restatement recognizes the validity of market indices and index funds as comparators in ERISA litigation. The Solicitor General and the First Circuit’s Brotherston do so as well.

2. Which party bears the burden of proof on the issue of causation of loss in 401(k)/403(b) litigation?
Answer: Section 100, comment f, of the Restatement provides as follows:

[W]hen a beneficiary has succeeded in proving that the trustee has committed a breach of duty and that a related loss has occurred, we believe that the burden of persuasion ought to shift to the trustee to prove, as a matter of defense, that he loss would have occurred in the absence of a breach.⁴⁰

As the Solicitor General, the Department of Labor, and the First Circuit’s Brotherston decision have all pointed out, this position is consistent with the common law of trusts.

At first glance, this would not appear to be a difficult decision for SCOTUS if they remain consistent with their previous decision in Tibble. Since the two key questions are not directly addressed by ERISA, the court would turn to the Restatement.

As noted herein, the Restatement does clearly address and answer both questions. Furthermore, several circuits have addressed both questions and the exact scenarios involved in Matney and have provided practical, fair, and well-reasoned decisions that are consistent with both ERISA, the Restatement, and the common law of trusts.

The ongoing division within the federal courts on ERISA issues, and the unwillingness of some courts to adopt the Restatement’s clear and equitable standards, reminds me of a quote by the late General Norman Schwarzkopf that I frequently used in my closing argument to a jury

The truth of the matter is that you always know the right thing to do. The hard part is doing it.

Hopefully, SCOTUS will be provided with the opportunity to do so by simply combining the Restatement with a little common sense and “humble arithmetic.”

Notes
1. Matney v, Barrick Gold of North America, No. 22-4045, September 6, 2023 (10th Circuit Court of Appeals (Matney 10th Circuit).
2. Solicitor General’s Brotherston amicus brief , 6-7. (Amicus brief)
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018). (Brotherston)
4. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
5. Amicus brief, 19.
6. Amicus brief, 20.
7. Amicus brief, 20.
8. Amicus brief, 20.
9. Amicus brief, 39.
10. Amicus brief, 19.
11. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
12. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017.
13. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
14.. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
15. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49.
16. 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
17. Amicus brief, 8.
18. Amicus brief, 8. (citing the Restatement (Third) of Trusts, Section 100, comment f (2012)
19. Amicus brief, 10-11.
20. Amicus brief, 11.
21. Brotherston, 39.
22. DOL’s Amicus brief in Pizarro v. Home Depot, 26.
23. Sacerdote v. New York Universit, 9 F.4th 95 (2d Cir. 2021). (Sacerdote)
24. Sacerdote, 107.
25. Sacerdote, 108.
26. Sacerdote, 108.
27. Sacerdote, 108.
28. Sacerdote, 113.
29. Simon Sinek, “Start With Why,” (Portfolio:London 2009).
30. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022). (TriHealth)
31. TriHealth, 453.
32. Albert v. Oshkosh Corp., 47 F.4th 570, 581 (7th Cir. 2022).
33. Sacerdote, 111.
34. Sacerdote, 111.
35. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022).
36. Amicus Brief, 8.
37. Amicus brief, 21.
38. Hughes v. Northwestern University, No. 18-2569 (7th Cir. 2022), 14 (“So “cost-conscious management is fundamental to prudence in the investment function,…” (citing RESTATEMENT (THIRD) OF TRUSTS § 90, cmt. B; see also id. § 88, cmt. A (“Implicit in a trustee’s fiduciary duties is a duty to be cost- No. 18-2569 15 conscious.”). “Wasting beneficiaries’ money is imprudent.” UNIF. PRUDENT INVESTOR ACT § 7, cmt. (UNIF. L. COMM’N 1995).
39. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study).
40. Restatement of the Law Third, Trusts copyright © 2007 by The American Law Institute. Reproduced with permission. All rights reserved.

Why Smart Fiduciaries Avoid Annuities: “Humble Arithmetic,” Annuities, and Fiduciary Liability

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

[A] victim to the relentless rules of humble Arithmetic. Remember, O stranger, ‘Arithmetic is the first of the sciences and the mother of safety.’
U.S. Supreme Court Justice Louis Brandeis

Fiduciary law is essentially a combination of trust, agency, and equity law. A fiduciary is always required to put their beneficiaries’ interests first, to always act in their beneficiaries’ best interests. As Justice Benjamin Cardozo wrote in Meinhard v. Salmon:

A [fiduciary] is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.¹

When a plaintiff’s attorney is involved in a case with catastrophic injuries, such as a wrongful death case, the defendant often suggests that the parties agree to a “structured settlement,” a settlement which usually involve some up-front money, but one in which the majority of damages are to be paid by periodic payments provided by an annuity.

People often ask me why I am so opposed to annuities. Part of my opposition to annuities is a result of my experiences with annuity wholesalers during my days as a compliance director. However, my opposition is due primarily from my experience as a plaintiff’s attorney.

When the defendant and their counsel propose a stated settlement amount, too many attorneys do not understand how to properly evaluate the value of the settlement/annuity. As a result, many plaintiff’s attorneys have faced malpractice actions for unintentionally misrepresenting the value of the settlement to their clients.

Today, many courts have addressed the fundamental fairness problem by requiring the defendant to provide the plaintiff and the court with the actual price that the defendant will have to pay for the annuity to be used in the settlement, the court taking the position that said price is the present value of the proposed settlement. Even now, some defendants refuse to disclose the actual price of the proposed annuity. In such cases, the plaintiff’s attorney can ask the court to approve a “qualified settlement fund,” into which the actual settlement funds will be temporarily deposited and then prudently invested.

The current attempt by the annuity industry to make inroads into 401(k) and 403(b) plans reminds me of the marketing ploys utilized by the annuity industry in connection with structured settlements. The annuity industry was telling the courts and anyone else who would listen that structured settlements and annuities were necessary because over 90 percent of personal-injury victims were dissipating the proceeds of their settlements within five years.

A NYU law student conducted a thorough research project and found that there was no empirical evidence to support such a claim.² The insurance and annuity industry admitted that there was no evidence to support the claim and instructed its members to stop using the claim.

Which brings us to the current campaign by annuity advocates to increase the use of annuities within 401(k) and 403(b) plans, the advocates arguing that plan participants desire “guaranteed income for life. But do plan sponsors and plan participants understand how such annuities work and the associated costs involved. As the late fee-only insurance adviser Peter Katt used to caution, “but at what cost?”

A CEO recently contacted me and asked me why I refer to annuities as “fiduciary traps.” I showed him the analysis shown below, a structured settlement analysis that I had once prepared for a case. He looked up and told he now understood why I referred to annuities as “fiduciary traps.” He asked me why these issues were never explained to plan sponsors in this way. My response was simple – “Would you include annuities in your plan provided with such information?”

The analysis below uses methodologies included in Paul Lesti’s excellent treatise on analysis of structured settlements.³ Lesti cautioned that

Many annuities are not for a specified number of years. Most annuities are payable for the life of the annuitant, possibly with some period certain.⁴

Lesti notes that analyzing annuities in terms of their present value, factoring in the time value of money, is one commonly used method used in analyzing annuities. However, Lesti cautions that an analysis based on present value alone may be misleading:

The more accurate method is to calculate the present value of each probable payment.⁵

In the case of a nonguaranteed annuity, it is necessary to calculate the probability that the person will be alive to receive each payment. Multiply the probability by the amount to be received, and then multiply this amount by the applicable discount factor.⁶

The chart below uses the suggested methodology, with a slight variation in the order of presentation to make the concept and impact of present value calculations a little easier to understand. The “twist” does not alter the end results.

As I tell my fiduciary risk management clients, always insist that the annuity salesperson provide you with a similar chart, showing the actual calculations and the breakeven point, the point at which the annuity owner could be said to receive a commensurate return on the original investment. Unless the plan participant/annuity owner will receive a commensurate return for the extra risks and costs associated with an annuity, a valid argument can be made under the common law of trusts that the investment results in a fiduciary breach due to the windfall issue. A basic tenet of equity law is that “equity abhors a windfall.”

The chart reflects an analysis of the purchase of a $250,000 annuity, paying a flat 4 percent a year, by a 65-year-old male. The last two columns of the chart show the results of a present value analysis of the annuity in question, one based on present value alone, the other based on present value with probability of receipt of payment factored in. The probability numbers are calculated from annual mortality tables. Note: The mortality numbers/factors shown are from a 2014 case and do not reflect the current mortality factor numbers.

The numbers in the last two columns break down the numbers at the 10, 20, and 30 year marks, with a final analysis if the annuitant were to reach age 100. Given the prospective annuity owner’s current life expectancy at age 65, approximately 17 years, the numbers speak for themselves. Explains why annuity issuers pay such high commissions for annuity sales. I would also submit that the numbers clearly establish the strength of a potential fiduciary breach claim against a plan sponsor for both prudence and loyalty, due to the lack of a commensurate return, resulting in a significant windfall in favor of the annuity issuer at the plan participant’s expense.

Annuity advocates often counter that annuity owners do care about present value calculations as long as they receive “guaranteed income for life.” Based on my personal experience, once annuity owners are provided with the relevant information and realize the true situation, they care deeply.

Annuity owners often realize that they cannot make ends meet with the income produced by an annuity alone. When I explain that they can sell their annuity, but that the price they will receive will be a deeply discounted number based on the annuity’s present value, they do care.

Going Forward
When I hear people talking about purchasing an annuity, whether it be a qualified annuity, an annuity purchased within a pension plan, or a non-qualified annuity, an annuity purchased outside a pension plan, I just wish I could perform a forensic analysis for them using Lesti’s methodology so they would have “sufficient information to make an informed decision,” the same standard required of plan sponsors seeking the safe harbor protection of ERISA Section 404(c). Plan sponsors considering offering annuity options within their plan must determine how, and if, they are going to provide such valuable information to each plan participant in order to meet the “sufficient information” requirement of section 404(c), or simply forego the potential protection offered by the section.

In my 42 years of practicing law, I have rarely seen an analysis of a life annuity that factors in both present value and the mortality/probability of receiving payments issues. The chart shown explains why prospective annuity customers are not provided with such an analysis.

The chart also supports one commentator’s suggestion that such present value calculations and charts “suggest that those providing annuities understand present value calculations, while those who are forced to purchase their products do not.”⁷ This lack of transparency allows the annuity industry to continue to recommend inequitable annuities and potentially expose plan sponsors and other investment fiduciaries to unnecessary fiduciary liability.

Both SECURE and SECURE 2.0 were intended to provide potential safe harbors for plan sponsors that choose to include annuities within their plans. Plan sponsors should note that those potential safe harbors apply to liability under ERISA. It appears that plan participants would still be able to sue plan sponsors under such common law causes of action such as negligence and fraud for inclusion of annuties, in any form, within a plan

Chris Tobe has discussed a number of the inherent issues connected with annuities, such as single entity credit risk, illiquidity, and excessives costs, on our “The CommonSense 401(k) Project) web site, Given the evidence provided by the chart herein and other such inherent issues with annuities, one can only wonder why plan sponsors would unnecessarily expose themselves to potential fiduciary liability by even considering including annuities in their plans. I guess it proves the truth of the saying, “common sense ain’t so common.”

ERISA does not require that plans offer any specific type of investment, including annuities. ERISA only requires that each investment option within a plan be legally prudent. So, again, why would plan sponsors even consider including annuities within their plan? Annuity advocates and plan sponsors argue that plan participants want choice, guaranteed income, and peace of mind in retirement. My response is that plan participants who still want to purchase annuities after being presented with all the relevant facts could still do sooutside the plan, without exposiing the plan and plan sponsors to an risk of fiduciary liability.

Just as I have consistently argued that cost-inefficient actively managed mutual funds do not constitute a legitimate “choice,” forensic analyses of annuities factoring in both present value and mortality issues clearly establish the legal imprudence of annuities. Proof of this can be provided by simply insisting that the annuity salesperson provide you with a forensic analysis chart that factors in both present value and mortality/probability of payment issues.

Both the legal and annuity industries are still awaiting decisions in both the Matney⁸ and Home Depot⁹ 401(k) litigation cases. The key issue in both cases is who has the burden of proof on the issue of causation of harm. A number of federal courts, the Solicitor General of the United States, and the Department of Labor have already opined that once the plan participants establish a fiduciary breach and a resulting loss, the plan sponsor has the burden of proving that their actions did not cause such losses. As these parties have pointed out, this is the only equitable result since only the plan sponsor knows why they made the decisions that resulted in a berach of their fiduciary duties.

I am on record as saying that I believe that the Matney and Home Depot decisions will ultimately result in increased 401(k) and 403(b) litigation, both between plans/plan participants and plans/plans advisers. I believe that the combination of the Active Management Value Ratio metric and forensic analyses of annuities using Lesti’s methodology will help plan participants carry their burden of proof, while making it very difficult for plan sponsors to carry their burden of proof.

The next 12 to 18 months promise to be very interesting, and telling, for 401(k) and 403(b) plan sponsors.

Notes
1. Meinhard v. Salmon, 249 N.Y. 458, 464 (1928).
2. Jeremy Babener, “Justifying the Structured Settlement Tax Subsidy: The Use of Lump Sum Settlement Monies,” NYU Journal of Law & Business (Fall 2009)
3. Paul J. Lesti, “Structured Settlements,” (Bancroft-Whitney Co.: 1986). (Lesti)
4. Lesti, 114.
5. Lesti, 114.
6. Lesti, 114.
7. Guy Fraser-Sampson, “No Fear Finance: An Introduction to Finance and Investment for the Non-Finance Professional,” (Kogan Page: 2011)
8. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022).
9. Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022), 24.

Copyright InvestSense, LLC 2023. 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.

Could the Matney and Home Depot Decisions Signal the End of the 401(k)/403(b) Litigation SNAFU? Are Plan Sponsors Really Ready?

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

People often ask me why I write and comment so much about the Matney case.¹ As a fiduciary risk management counsel, my job is to monitor developments in fiduciary law and help my fiduciary clients avoid unnecessary liability risk exposure.

Three issues have continued to trouble fiduciary law: the “menu of options” defense, the issue of whether index funds are meaningful comparators in assessing fiduciary prudence, and the issue of who has the burden of proof as to loss causation regarding plan participant losses. The Hughes² decision finally resolved the “menu of options” issue. Section 100 of the Restatement (Third) of Trusts should resolve the “meaningful comparators” issue.

The Matney case, as well as the Home Depot case, involve a common question, namely which party in a 401(k)/403(b) litigation action has the burden of proof on the issue of loss causation. The problem is that there is currently a split of opinion on the question in the federal courts, effectively denying some plan participants the rights and protections guaranteed to them under ERISA.

Legal Background – Brotherston
The issue of who carries the burden of proof on the issue of causation was a key issue in the First Circuit Court of Appeal’s Brotherston decision.³ The First Circuit relied heavily on the common law of trusts in ruling that the burden of proof on causation necessarily belonged to the plan sponsor. The Court noted that fiduciary prudence vis-à-vis causation is process oriented, determined by looking at the prudence of the process employed by a plan sponsor in selecting investment options for a plan, rather than at the ultimate performance of the investment option itself.

The Court noted that since the process used by the plan sponsor is typically known only to the plan sponsor, and since many courts do not plan participants the opportunity for discovery to learn what processes, if any, were used by the plan sponsors, placing the burden of proof of causation on the plan sponsor is both inequitable and inconsistent with the standards established by the common law of trusts. Numerous courts have since adopted the First Circuit’s position.

In an interesting development, the Sixth Circuit recently noted the inequity of requiring plan participants to prove that the plan’s fiduciary process was flawed without the benefit of being allowed to discover exactly what the plan sponsor’s process was, stating that

[D]iscovery 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…. 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.⁴

Legal Background – Sacerdote
Another key case on the issue on who has the burden of proof on the issue of causation is the Sacerdote v. New York University (NYU) case.⁵ Some of the facts in this case border on the unbelievable and the absurd, including some members of the investment committee testifying that they did not even know that they were on the investment committee and others testifying that they did not know what they were doing and why they were on the investment committee. Nevertheless, the district court ruled in favor of NYU.

On appeal, the Second Circuit of Appeals reversed several of the district court’s key ruling, including the court’s ruling on the fiduciary prudence of the investment options chosen by the plan. The Court started out by stating the applicable standard for consideration of a motion to dismiss in 401(k) litigation:

[The fiduciary prudence] standard focuses on a fiduciary’s conduct in arriving at an investment decision, not on its results, and asks whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment.⁶

A claim for breach of the duty of prudence will “survive a motion to dismiss if the court, based on circumstantial factual allegations, may reasonably infer from what is alleged that the process was flawed” or “that an adequate investigation would have revealed to a reasonable fiduciary that the investment at issue was improvident.”⁷

The Court then addressed the case itself:

Plaintiffs allege that this information was included in fund prospectuses and would have been available to inquiring fiduciaries when the fiduciaries decided to offer the funds in the Plans. In sum, plaintiffs have alleged “that a superior alternative investment was readily apparent such that an adequate investigation” —simply reviewing the prospectus of the fund under consideration—”would have uncovered that alternative.” On review of a motion to dismiss, we must draw reasonable inferences from the complaint in plaintiffs’ favor.⁸

While the plausibility standard requires that facts be pled “permit[ting] the court to infer more than the mere possibility of misconduct,” we do not require an ERISA plaintiff “to rule out every possible lawful explanation for the conduct he challenges.” To do so “would invert the principle that the complaint is construed most favorably to the nonmoving party” on a motion to dismiss.⁹

Second, we caution against overreliance on cost ranges from other ERISA cases as benchmarks. While such comparisons may sometimes be instructive, their utility is limited because the assessment of any particular complaint is a “context-specific task.” We cannot rule out the possibility that a fiduciary has acted imprudently by including a particular fund even if, for example, the fees that fund charged are lower than a fee found not imprudent in another case.¹⁰

When the university attempted to present some notes as evidence that the investment committee did employ a prudent process in reviewing and selecting the plan’s investment option, the Court cautioned that simply employing some semblance of a “process” does not automatically ensure compliance with ERISA.

The fact that one document purports to memorialize a discussion about whether or not to offer retail shares does not establish the prudence of that discussion or its results as a matter of law.¹¹

We have no quarrel with the general concept of using retail shares to fund revenue sharing. But, there was no trial finding that the use here of all 63 retail shares to achieve that goal was not imprudent. Simply concluding that revenue sharing is appropriate does not speak to how the revenue sharing is implemented in a particular case. We do not know, for example, whether revenue sharing could prudently be achieved with fewer retail shares.¹²

The Court then addressed a key problem in far too many dismissals of 401(k)/403(b), courts confusing “losses” with “damages,” and the party bearing the burden of proof as to each.

Moreover, we are hard-pressed to rely on the discussion of loss that the district court did undertake because the discussion was somewhat unclear in several respects. It conflated loss with damages, appeared to answer a question the court claimed to leave undecided, and effectively misallocated the burden of proof on damages.¹³

To be clear, these terms are not interchangeable. Loss is measured in this context by “a comparison of what the [p]lan actually earned on the investment with what the [p]lan would have earned had the funds been available for other [p]lan purposes. If the latter amount is greater than the former, the loss is the difference between the two.” The question of how much money should be awarded to the plaintiffs in damages is distinct from, and subsequent to, whether they have shown a loss. The district court’s conflation of the two concepts saps our confidence in its analysis on this subject.¹⁴

Although plaintiffs bear the burden of proving a loss, the burden under ERISA shifts to the defendants to disprove any portion of potential damages by showing that the loss was not caused by the breach of fiduciary duty. This approach is aligned with the Supreme Court’s instruction to “look to the law of trusts” for guidance in ERISA cases. Trust law acknowledges the need in certain instances to shift the burden to the trustee, who commonly possesses superior access to information.¹⁵

The Court then cited the First Circuit’s observation in Brotherston that “[i]t 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.”¹⁶

The DOL’s Amicus Brief
The Department of Labor (DOL) recently filed a welcome amicus brief in the Home Depot 401(k) action addressing the issue of the party carrying the burden of proof regarding loss causation in 401(k)(403(b) litigation.

Under the correct burden-shifting framework, where Home Depot (the movant) bears the burden to disprove loss causation, Home Depot could have prevailed at summary judgment on that element only if it presented evidence allowing a reasonable fact finder to conclude that the alleged breach did not cause the Plan’s losses. In short, Home Depot would have to prove “that a prudent fiduciary would have made the same decision.”¹⁷

The DOL then provided the potential “shot heard around the ERISA world,” a statement that will no doubt re repeated in future 401(k)/403(b) litigation, especially motions to dismiss:

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.¹⁸ (citing Sacerdote)

Common Law, ERISA, and the Restatement of Trusts
In the Tibble decision¹⁹, SCOTUS recognized the Restatement of Trusts (Restatement) as a valuable resource in resolving questions involving questions regarding a fiduciary’s legal duties. SCOTUS also noted that both the Restatement and ERISA are largely based on the common law of trusts.

Two dominant themes that run throughout ERISA are cost-consciousness and importance of diversification to minimize the risk of large losses. Regarding cost-consciousness, the Restatement, sets out three important considerations:

1. Section 88, comment b, of the Restatement states that fiduciaries have a duty to be cost-conscious.

2. Section 90, aka the “Prudent Investor Rule,” comment f, states that a fiduciary has a duty to seek the highest rate of return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of expected return.

3. Section 90, comment h(2), goes even further regarding a fiduciary’s duty to be cost-efficient, stating that due to the extra costs and risks typically associated with actively managed mutual funds, such funds should not be recommended to and/or used unless their use/recommendation can be “justified by realistically evaluated return calculations” and can be “reasonably expected to compensate” for their additional costs and risks.

Studies have consistently shown that the overwhelming majority of actively managed funds are not cost-efficient.

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

The Active Management Value Ratio (AMVR)
Several years ago I created a metric, The Active Management Value Ratio (AMVR), which allows investors, investment fiduciaries, and attorneys to quickly evaluate the cost-efficiency of an actively managed fund. The AMVR is based on the research and concepts of noted investment experts such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, Burton G. Malkiel. The latest iteration of the AMVR includes the valuable research of Ross Miller, whose Active Expense Ratio metric factors in the correlation of returns between an actively managed fund and a comparable index fund to provide a more accurate evaluation of cost-efficiency.²⁴

The beauty of the AMVR is its simplicity. In interpreting a fund’s AMVR scores, an attorney, fiduciary or investor only must answer two questions:

1. Does the actively managed mutual fund produce a positive incremental return?
2. If so, does the fund’s incremental return exceed it incremental costs?

If the answer to either of these questions is “no,” then the fund does not qualify as cost-efficient under the Restatement’s guidelines.

The Fiduciary Prudence Score^TM is a proprietary trademark of InvrestSense, LLC. The proprietary trademark for the actively managed fund shown in the referenced AMVR slide would be negative seven (-7.00)

The AMVR only requires the ability to do simple arithmetic calculations using performance and costs data that is freely available on several web sites such as morningstar.com, yahoo.com, and marketwatch.com. For more information on the AMVR, click here.

Going Forward
While the Brotherston and Sacerdote are valuable decisions in deciding the issue as to the party required to carry the burden of proof regarding loss causation in 401(k)/403(b) litigation, The DOL’s amicus brief provides the quick and easy answer for resolving the pending Matney and Home Depot cases.

As I always remind my fiduciary clients, prudent plan sponsors do not select cost-inefficient investment options for their plan.

By using the AMVR to evaluate the fiduciary prudence of potential plan investment options and the potential resulting loss, 401(k)/403(b) plan sponsors can minimize the risk of unnecessary fiduciary liability exposure and improve the plan participants’ odds of “retirement readiness. At the same time, ERISA plaintiff attorneys can use the AMVR to evaluate the fiduciary prudence of potential plan investment options and calculate any losses due to non-compliance with ERISA.

The DOL’s amicus brief, together with the Brotherston and Sacerdote decisions, have provided SCOTUS with the necessary evidence as to why the burden of proof as to loss causation, by necessity, must either be shifted to the plan sponsor or plan participants must be allowed to have “controlled,” or limited, discovery to determine the prudence of the process the plan used in investigating and evaluating the investment options chosen by the plan. Now the courts have the opportunity to do so.

Notes
1. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022). (Matney)
2. Hughes v. Northwestern University, 142 S.Ct. 737 (2022).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018). (Brotherston)
4. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022).
5. Sacerdote v. New York University, 9 F.4th 95 (2021) (Sacerdote).
6. Sacerdote, 107.
7. Sacerdote, 108.
8. Sacerdote, 108.
9. Sacerdote, 108.
10. Sacerdote, 108-109.
11. Sacerdote, 109.
12. Sacerdote, 111.
13. Sacerdote, 112.
14. Sacerdote, 112.
15. Sacerdote, 113.
16. Sacerdote, 113.
17. Department of Labor amicus brief in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022), 24. (Amicus Brief). http://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
18. Amicus Brief, 26
19. Tibble v. Edison International, 135 S. Ct 1823 (2015)
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.&nbsp.
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. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926.
25. Amicus Brief, 26.

Copyright InvestSense, LLC 2023. 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.

3 Key Questions for Plan Sponsors on Annuities, “Guaranteed Income,” and Fiduciary Liability Under ERISA

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

Seems that social media and trade publications are focused on the issue of “guaranteed income” options within ERISA plans, with various studies indicating that plan participants would be interested in a source of guaranteed income during retirement. That response should not come as a surprise to anyone.

Would the results be different if the question was framed differently by adding material information. Framing refers to presenting situations in such a way as to influence an individual’s response by appealing to the individual’s cognitive biases. A primary example is to present a scenario where one response will result in gain, while the other response will result in a loss.

So, presenting a poll or the results of a study which indicates that retirees would be interested in a source of guaranteed income during retirement, or any time for that matter, is hardly earth shattering. However, what would be the likely results if we frame the same question slightly different to disclose additional requirements, such as the following:

Would you be interested in a product that can guarantee you for income for life? The only requirement to receive that lifetime stream of income is that you will have to surrender both control of the product and the accumulated value within the product to the company offering the product, with no guarantee of receiving a commensurate return in exchange for surrendering such value and control, and agreeing that the company offering the product, not your heirs, receives any residual value in your account when you die.

I have never had one person respond positively to my version of the “guaranteed income”/annuity question. During my compliance days, my brokers became very familiar with my mantra – “all God’s children do not need an annuity.” A well-known saying within the annuity industry is that “annuities are sold, not bought.” Plan sponsors should remember that saying and the reasoning behind it.

Annuity advocates will often point out that annuities often offer so-called “riders” that do guarantee a return of the annuity owner’s principal to the annuity owner’s heirs…for an additional price. With annual fees within an annuity often running two percent or more, the additional fee for “riders” serves to further reduce annuity owner’s end-return.

As both the Department of Labor and the federal General Accountability Office have pointed out, each additional one percent in fees and expenses reduces an investor’s end-return by approximately 17 percent over a twenty-year period.¹ Riders often cost an additional one percent or more of the annuity’s accumulated value. When combined with an annuity’s other annual costs, it is easy to see how over half of an annuity owner’s end-return can be lost in an annuity’s annual fees (3 times 17).

Annuities, Plan Sponsors, and the Fiduciary Liability Gauntlet
A CEO invited me to lunch recently to discuss the potential liability issues of offering annuities within his company’s 401(k) plan. Before lunch was over, two other executives sitting nearby came by our table and asked me to call them to discuss the issue.

Full disclosure – I do not like annuities. Never have, never will. My strong dislike of annuities is due primarily to my experience with the annuity industry during my time as a plaintiff’s attorney. I was involved in litigating some medical malpractice and wrongful death cases. When a case potentially involves significant monetary damages, the defendant’s insurer typically suggests a structured settlement involving an annuity.

As a plaintiff’s attorney, if the defense offers to settle for a million dollars, the plaintiff’s attorney has to ensure that the plaintiff is actually going to receive a settlement with a present value of a million dollars. Failure to do so will typically result in a malpractice claim.

The courts have consistently held that the present value of a settlement involving an annuity is the purchase price of the annuity. However, many insurance companies refuse to disclose the actual purchase price of the annuity since it is typically well below the agreed upon settlement price, ensuring them a windfall. Fortunately, the plaintiff can avoid such dishonesty by asking the court to approve of a “qualified settlement fund, ” into which the settlement proceeds are paid so that the plaintiff can purchase an annuity at a fair price and avoid full and immediate taxation of the settlement proceeds.

I see a similar situation potentially developing in the annuity industry’s campaign to offer more annuity products within pension plans. As a fiduciary risk management counsel, my job is to explain the potential fiduciary liability pitfalls to plan sponsors in order to avoid unnecessary liability exposure. In my presentations, I currently focus on three areas: (1) a plan sponsor’s duty to personally investigate and evaluate each investment option within a plan, (2) ERISA Section 404(c)’s “adequate information to make an informed decision” requirement, and (3) a plan sponsor’s actual fiduciary duties under ERISA Section 404(a).

ERISA Section 404(a)’s “Knew or Should Have Known” Standard
Section 404 sets out a plan sponsor’s fiduciary duty of prudence:

a fiduciary shall discharge his duties with respect to a plan …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

In determining whether a trustee has breached his duties, the court examines both the merits of the challenged transaction(s) and the thoroughness of the fiduciary’s investigation into the merits of the transaction(s).³

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard. (citing Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983); Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981). The determination of whether an investment was objectively imprudent is made on the basis of what the trustee knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate. It is the imprudent investment rather than the failure to investigate and evaluate that is the basis of suit; breach of the latter duty is merely evidence bearing upon breach of the former, tending to show that the trustee should have known more than he knew.# (emphasis added)⁴

While courts recognize, even encourage, the use of third-parties in the fiduciary’s investigation and evaluation process, the courts have consistently warned that plan sponsors and other plan fiduciaries may not blindly rely on such experts, especially experts that are commission salespersons.

Blind reliance on a broker whole livelihood was derived from the commissions he was able to garner is the antithesis [of a fiduciary’s duty to conduct an] independent investigation”⁵

“The failure to make an independent investigation and evaluation of a potential plan investment is a breach of fiduciary duty.”⁶

Sponsors must conduct a thorough and objective investigation and evaluation in selecting investment products for a plan. Fiduciary prudence focuses on the process used by a plan sponsor in investigating and evaluating the investment products chosen for a plan, not the eventual performance of the product. In assessing the process used by a plan sponsor, the court evaluate prudence in terms of both procedural and substantive prudence.

Procedural prudence focuses on whether the fiduciary utilized appropriate methods to investigate and evaluate the merits of a particular investment. Substantive prudence focuses on whether the fiduciary took the information from the investigation and made the same decision that a prudent fiduciary would have made.

The Tatum v. RJR Pension Inv. Committee decision⁷ provides an excellent analysis of various types of fiduciary prudence – objective prudence, procedural prudence, and subjective prudence. It also involves the analysis of an annuity, although defined benefit plan context.

The court first addressed the concept of “objective prudence, stating that

A decision is objectively prudent is a hypothetical prudent fiduciary would have the same decision.⁸ (emphasis added)

I have deliberately added emphasis to the word “would,” as it was a pivotal issue in the court’s decision. The plan sponsor had argued, and the lower court had accepted their argument, that it was sufficient to show that a hypothetical prudent fiduciary “could” have made the same decisio.

The Fourth Circuit Court of Appeals rejected that argument, stating that the chosen word with regard to the applicable fiduciary prudence standard was more than just a matter of semantics.

ERISA requires fiduciaries to employ “appropriate methods to investigate the merits of the investment and to structure the investment” as well as to “engage in a reasoned decision-making process, consistent with that of a `prudent man acting in [a] like capacity.'”⁹

In other words, although the duty of procedural prudence requires more than “a pure heart and an empty head,” courts have readily determined that fiduciaries who act reasonably — i.e., who appropriately investigate the merits of an investment decision prior to acting — easily clear this bar.¹⁰

[I]n matters of causation, when a beneficiary has succeeded in proving that the trustee has committed a breach of trust and that a related loss has occurred, the burden shifts to the trustee to prove that the loss would have occurred in the absence of the breach.” (citing Restatement (Third) of Trusts § 100, cmt. f (2012))¹¹

As the Supreme Court has explained, the distinction between “would” and “could” is both real and legally significant….[C]ould” describes what is merely possible, while “would” describes what is probable.¹²

The “would have” standard is, of course, more difficult for a defendant-fiduciary to satisfy. And that is the intended result. “Courts do not take kindly to arguments by fiduciaries who have breached their obligations that, if they had not done this, everything would have been the same.” …We would diminish ERISA’s enforcement provision to an empty shell if we permitted a breaching fiduciary to escape liability by showing nothing more than the mere possibility that a prudent fiduciary “could have” made the same decision.¹³ (cites omitted

The court then went on to address the issue of substantive prudence:

a decision is “objectively prudent” if “a hypothetical prudent fiduciary would have made the same decision anyway.”¹⁴

As mentioned earlier, substantive prudence focuses on the plan sponsor’s consideration of the facts uncovered in its investigations and whether the plan sponsor properly factored in such information and made a legally proper decision.

Other courts have identified key factors that plan sponsors must address in considering annuities.

A fiduciary must consider any potential conflict of interest, such as a potential reversion of plan assets, and structure its investigation accordingly.¹⁵

Just as with experts’ advice, blind reliance on credit or other ratings is inconsistent with fiduciary standards.¹⁶ 

With regard to the potential reversion of plan assets involving annuities, I would (and have) argued that the fact that reversion would be to the annuity issuer is especially egregious and constitutes a breach of a plan sponsor’s fiduciary duties of both loyalty and prudence based upon the fact that such a reversion would constitute a windfall for the annuity issuer at the annuity owner’s. Equity law is a component of fiduciary law, and “equity abhors a windfall.”

The court concluded by emphasizing that the controlling criteria was whether an annuity under consideration was in the best interest of the plan participants and their beneficiaries. The question will be whether plan sponsors can obtain the necessary information to independently evaluate and verify the accuracy, as well as interpret the implications of the annuity information they can uncover.

For instance, will plan sponsors be able to determine whether plan participants will even be able to break-even on a particular annuity, especially if the annuity issuer retains the right to reset the terms? Will plan sponsors be able to understand the difference between an ordinary annuity and an annuity due and provide plan participants with the information on the financial implications of each, e.g., breakeven points?

ERISA’s “Adequate Information to Make an Informed Decision” Requirement
Plan sponsors typically try to qualify as a 404(c) plan in order to receive immunity from liability for the ultimate performance of the plan participants’ investment choices. Qualification for such protection requires compliance with approximately twenty requirement. As a result, many plan sponsors mistakenly believe they are in compliance with 404(c) when they actually are not.

An “ERISA section 404(c) Plan” is an individual account plan described in section 3(34) of the Act that:

(i) Provides an opportunity for a participant or beneficiary to exercise control over assets in his individual account (see paragraph (b)(2) of this section); and

(ii) Provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his account are invested (see paragraph (b)(3) of this section).

(2) Opportunity to exercise control.

(i) a plan provides a participant or beneficiary an opportunity to exercise control over assets in his account only if:

(B) The participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed investment decisions with regard to investment alternatives available under the plan, and incidents of ownership appurtenant to such investments. For purposes of this paragraph, a participant or beneficiary will be considered to have sufficient information if the participant or beneficiary is provided by an identified plan fiduciary (or a person or persons designated by the plan fiduciary to act on his behalf)…¹⁷

As pointed out earlier, the financial services industry, in particular the insurance/annuity industry, are not known for their transparency and full disclosure. Transparency and full disclosure are the financial services kryptonite. Anytime there is any mention of a true fiduciary standard for the industry, the industry’s lobbyists grab their checkbooks and head toward Capitol Hill, as the financial services industry knows that few, if any, of its products could comply with a true fiduciary standard. They just hope that plan sponsors and consumers never realize that fact.

Annuities present a number of challenges for plan sponsors hoping to qualify for 404(c) protections. Annuities are extremely complex, and deliberately so. There is a saying within the annuity industry, “annuities are sold, not bought.” Anyone who truly understands annuities would never consider buying one, especially when viable, cost-efficient alternatives are readily available that do not require the investment owner to agree to the unnecessarily harsh terms required by annuity companies.

Annuities have been described as a bond wrapped in an expensive insurance wrapper. The primary issue with commercial annuities is the associated costs, both in terms of monetary costs and opportunity costs in terms of other financial goals, such as estate planning. Annuity advocates will often turn to their “guaranteed income for life” and “no loss” mantra. Annuity opponents will counter with their “at what cost” mantra and the viable alternatives available. Financial service publications have run articles explaining how financial advisers can help their customers create viable, cost-efficient annuity substitutes.

With annual fees/spreads often in the range of two percent or more, plan sponsors should remember the findings of both the Department of Labor and the General Accountability Office that each additional one percent in fees reduces an investor’s end-return by approximately seventeen percent over a twenty-year period. Add a rider charging an additional annual fee of one percent and the investor now faces a reduction of over half of their end-return. Not sure how a plan sponsor can explain the prudence of including annuities reducing end-returns by one-third to one-half, or more, over more cost-efficient, investor friendly alternatives.

There is no requirement that a 401(k) plan qualify as a 404(c) plan. However, the inability to qualify as a 404(c) plan potentially raises a number of fiduciary prudence and loyalty questions. Given the annuity industry’s unwillingness to provide material information about their products, how can a plan sponsor perform the legally required independent and objective investigation and evaluation required by ERISA? Likewise, how will a plan sponsor provide the ongoing monitoring of each annuity and annuity related product offered within a plan?

If a plan offers annuities which allow the annuity provider to reset or otherwise change the terms of the annuity to protect and benefit the annuity issuer, what are the options and potential consequences for plan participants? An even more basic question for plan sponsons is how do they determine whether sufficient information has been, and will continue to be, provided. Remember, plan sponsors that chose to blindly rely on third-party information face an unforgiving legal system. These are just some samples of legal liability issues that plan sponsors should consider before choosing to include annuity options within a 403(k) or 403(b) plan.

Annuities and ERISA Requirements
ERISA does not expressly require plan sponsors to offer annuities, in any form, within a 401(k) or 403(b) plan. It’s just that simple.

In fact, ERISA does not expressly require a plan to offer any specific type of investment product. ERISA 404(a) only requires that each investment option within a plan be prudent. SCOTUS resolved that issue in the Hughes v. Northwestern University case.

So, the obvious question is why, given the various hurdles and the potential fiduciary liability traps inherent with annuities, would a plan sponsor voluntarily expose themselves to unnecessary fiduciary liability exposure? After all, a plan participant wanting to purchase an annuity could easily do so outside of the plan, without creating any potential liability issues for the plan sponsor.

Plan sponsors often try to justify the inclusion of an otherwise legally imprudent investment option based upon a desire to provide plan participants with “choices.” A legally investment option never has been, and never will be, a legally valid investment “choice.” The fact that a plan sponsor would even include a legally imprudent investment, e.g., a cost inefficient actively managed mutual fund, simply serves as a red flag for regulators with regard to the overall prudence of the plan’s selection process.

The good news is that it is relatively simple to design and maintain an cost-effective and ERISA compliant 401(k) or 403(b) plan. The bad news is that far too few plan sponsors do so.

Going Forward

[A] fiduciary satisfies ERISA’s obligations if, based upon what it learns in its investigation, it selects an annuity provider it “reasonably concludes best to promote the interests of [the plan’s] participants and beneficiaries.”¹⁹  271.

Based on the information presented herein and a plan sponsor’s fiduciary duties of prudence and loyalty, key questions in future 401(k)/403(b) litigation involving the inclusion of annuities and/or annuity related products in plans could/should include

(1) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan when that annuity requires the annuity owner to surrender both the investment contract and the accumulated value within the annuity without any guarantee of a commensurate return?

(2) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan when the terms of the annuity contract legitimate questions as to the odds of the annuity owner ever breaking even and, if so, how long it would take?

(3) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan if the annuity issuer reserves the right to reset the terms and guarantees within the annuity and impact the results of questions (1) and (2).

(4) Would a prudent plan sponsor decide to include an annuity as an investment option within a plan if the fees were so excessive as to potentially reduce an annuity owner’s end-return by one-third or more?

(5) Under the SECURE Act, plans sponsors are protected from liability in the event that annuities offered within their plan are unable to honor their financial commitments under their contracts. Yet, plan participants who purchase such annuities within a plan are not protected against loss in such circumstances. Given the obvious inequity in the event of such a situation, where you are protected but plan participants are not, would you consider your decision to offer annuities in your plan to be a breach of your fiduciary duties of prudence and/or loyalty?

If, as many ERISA attorneys expect, SCOTUS rules that the burden of proof as to causation shifts to the plan sponsor once the plan participants prove a fiduciary breach and resulting loss, these are questions that plan sponsors are going to be forced to face in future 401(k)/403(b) litigation. The answers, and resulting liability, would appear to be readily apparent.

While most people would agree that the concept of “guaranteed income” is highly desirable, from a legal and fiduciary liability perspective, the concept always needs to be balanced and conditioned on the question of “at what cost?” As mentioned earlier, in this case, “cost” would need to consider not only financial cost, but also opportunity costs such as the impact on estate planning and other types of financial planning.

Many would argue that the various costs and concessions associated with annuities, in any form, are simply not worth the “costs,” especially when other equally effective and more cost-efficient alternatives and strategies are available, such as dividends and bonds, e.g., Treasury and corporate, and laddering such bonds. Corporate trust departments often rely on the dividends on utility securities for guaranteed income. Trusts departments and some fiduciaries have been known to create their own annuities using a combination of bonds, life insurance, and index mutual funds.

I am on record as predicting that the defined contribution arena is going to undergo a significant change in the next 12-18 months, especially in the area of litigation, as a result of the pending decisions in the Matney and Home Depot 401(k) cases. A key question in both cases is which party carries the burden of proof on the issue of causation in defined contribution litigation.

I believe that both cases will result in the burden of proof on the issue of causation in 401(k) /403(b) litigation being shifted to the plans. As a result, I believe that there will be a significant increase in the number of cases litigated, both between plans/plan participants and plans/plan advisers, due largely to the fact that most plans cannot and will not be able to successfully meet the burden of proving that that their investment selections did not play a role in causing losses sustained by plan participants.

As I explain to my fiduciary risk management clients, there are some well-recognized fiduciary standards that should be followed in evaluating and selecting investments offering guaranteed income. Exposing a plan to unnecessary fiduciary liability exposure is one of those standards, with my corollary for fiduciaries being “annuities – don’t even go there.”

Previous posts on the unnecessary liability exposure that annuities create for defined contribution plans can be found here, here, and here

Notes
1. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (“DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”).
2. 29 C.F.R. § 2550.404(a)-1; 29 U.S.C. § 1104(a).
3. The failure to make any independent investigation and evaluation of a potential plan investment is a breach of fiduciary obligations. Fink v. National Savs. & Trust Co., 772 F.2d 951, 957 (D.C. Cir. 1985) (Fink), In re Enron Corp. Securities, Derivative “ERISA“, 284 F.Supp.2d 511, 549-550, Donovan v. Cunningham, 716 F.2d at 1467.⁵²
4. Fink, 962. (Scalia dissent)
5. Liss v. Smith, 991 F. Supp. 278, 299.
6. United States v. Mason Tenders Dist. Council of Greater NY,, 909 F. Supp 882, 887 (S.D.N.Y. 1995)
7. Tatum v. RJR Pension Inv. Committee, 761 F.3d 346 (4th Cir. 2014). (Tatum).
8. Tatum, 363.
9. Tatum, 358.
10. Tatum, 363.
11. Bussian v. RJR Nabisco, Inc., 223 F.2d 286, 300 (5th Cir. 2000). (Bussian)
12. Tatum, 365.
13. Tatum, 365.
14. Tatum, 363; Bussian, 300 (5th Cir. 2000).
15. Bussian, 300.
16. Bussian, 301.
17. 29 C.F.R. § 2550.404(c); 29 U.S.C. § 1104(c).

Resources
Collins, P.J., Lam, H., & Stampfi, J. (2009) Equity indexed annuities: Downside protection, but at what cost? Journal of Financial Planning, 22, 48-57.

FINRA Investor Insights (2022) The Complicated Risks and Rewards of Indexed Annuties  The Complicated Risks and Rewards of Indexed Annuities | FINRA.org

FINRA Investor Alert (2003) Variable Annuities: Beyond the Hard Sell

Frank, L., Mitchell, J. & Pfau, W. Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios, Journal of Financial Planning, April 2014, 38-47. 

Katt, P. (November 2006) The Good, Bad, and Ugly of Annuities AAII Journal, 34-39.

Lewis, W. Chris. 2005. A Return-Risk Evaluation of an Indexed Annuity Investment.” Journal of Wealth Management 7, 4.

McCann, C. & Luo, D. (2006). An Overview of Equity-Indexed Annuities. Working Paper, Securities Litigation and Consulting Group.

Milevsky, M. & Posner, S. The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126.

Olson, J. Index Annuities: Looking Under the Hood. Journal of Financial Services Professionals. 65-73 (November 2017),

Reichenstein, W. Financial analysis of equity-indexed annuities. Financial Services Review, 18 (2009) 291-311.

Reichenstein, W. (2011), Can annuities offer competitive returns? Journal of Financial Planning, 24, 36.

Securities and Exchange Commission. (2008) Investor Alerts and Bulletins: Indexed Annuties SEC.gov | Updated Investor Bulletin: Indexed Annuities

Sharpe, W.F. (1991) The arithmetic of active management. Financial Analysts Journal, 47, 7-9.

Terry, A. & Elder, E. (2015) A further examination of equity-indexed annuities. 24, 411-428.

Copyright InvestSense, LLC 2023. 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.

2Q 2023 “Cheat Sheets”: Plan Sponsors’ IDK/FOFO Strategy and the Future of Fiduciary Liability and Litigation

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

An analysis of the 2Q “cheat sheets” can be summed up quite simply – “the song remains the same.” None of the six funds qualified for an AMVR score based on either the 5 or 10-year analysis, meaning that the funds proved to be cost-inefficient, and thus legally imprudent, under the standards established by the Restatement (Third) of Trusts (Restatement). Readers are reminded that InvestSense bases its AMVR analysis of actively managed funds on incremental risk-adjusted returns and incremental correlation-adjusted costs, as explained later herein

For new followers, the “cheat sheets” provide a 5 and 10-year cost-efficiency analysis of the non-index funds in the ten most commonly used funds in U.S. defined contribution plans, based on “Pensions & Investments” annual poll. But this trend has even more relevance given the amicus brief that the Department of Labor (DOL) filed in the Home Depot 401(k) case currently pending in the 11th Circuit Court of Appeals. As the DOL pointed out in the amicus brief, the message within the brief was intended for the 10th Circuit as well, as they consider the same question in the Matney case.

First, a few of the pertinent quotes from the amicus brief.

ERISA is silent on who bears the burden of proving loss causation in fiduciary breach cases.¹

As the Supreme Court and this Court have recognized, where ERISA is silent, principles of trust law—from which ERISA is derived—should guide the development of federal common law under ERISA. Trust law provides that once a beneficiary establishes a fiduciary breach and a related loss, the burden on causation shifts to the fiduciary to show that the loss was not caused by the breach.²

This burden-shifting framework reflects the trust law principle that “as between innocent beneficiaries and a defaulting fiduciary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty.”³ 

Trust law requires breaching fiduciaries to bear the risk of proving loss causation because fiduciaries 14 often possess superior knowledge to plan participants and beneficiaries as to how their plans are run. (citing Restatement (Third) of Trusts § 100 cmt. f)⁴

In short, [a plan sponsor] has to prove “that a prudent fiduciary would have made the same decision.”⁵ (emphasis added)

At this point, the DOL made an interesting observation, citing the Second Circuit’s Sacerdote v. New York University decision, in particular the Court’s observation that

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.⁶

Proving Fiduciary Breach and Loss
The DOL’s amicus brief relied heavily on the common law of trusts. This is appropriate given the fact that the courts have consistently noted that ERISA is essentially the codification of the common law of trusts. The Restatement is just that, a restatement of the common law of trusts, which is why SCOTUS recognized the Restatement as a valid resource in resolving fiduciary disputes.

Two dominant themes throughout ERISA are cost-consciousness/cost-efficiency and diversification. In my role as a fiduciary risk management counsel, I focus on three key Restatement provisions addressing cost-consciousness:

So, with these three principles in mind, how do plaintiffs establish both the plan sponsor’s breach of their fiduciary duties and the resulting loss?

Actively managed mutual funds still dominate most 401(k) and 403(b) plans. A couple of years ago, I created a simple metric, the Active Management Value Ratio^TM (AMVR). The AMVR allows plans sponsors and other fiduciaries, as well as investors and attorneys, to quickly and easily assess the prudence of an actively managed funds against a comparable index fund.

One of the most common actively managed funds in 401(k) and 403(b) plans is Fidelity’s Contrafund Fund, K shares (FCNKX). A five-year and a ten-year AMVR analysis of FCNKX is shown below.

An actively managed fund’s AMVR score is calculated by dividing the fund’s incremental correlation-adjusted costs by its incremental risk-adjusted return. The costs and return calculations are based on comparisons to a comparable index fund.

The AMVR slides shown above also show how the prudence/imprudence of an actively managed fund can quickly be determined by just answering two questions:

(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?
(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?

If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and imprudent according to the Restatement’s prudence standards and should be avoided. The goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental return), but equal or less than “1” (indicating that the fund’s incremental costs did not exceed the fund’s incremental return).

Assuming that the burden of proof on causation is shifted to the plan sponsor, what is the likelihood that the plan sponsor could successfully carry such burden, could prove “that a prudent fiduciary would have made the same decision?”⁷

In the five-year analysis, FCNKX failed to even produce a positive incremental risk-adjusted return. Strike One.

If you treat the underperformance (-1.45) as an opportunity cost and combine it with the incremental nominal cost (0.42), the projected loss in end-return over a twenty-year period would be approximately 32 percent. The projected loss would be even greater, approximately 81 percent, if a more realistic cost analysis was conducted using the Active Expense Ratio. Strike Two.

One often overlooked benefit of the AMVR is that it indicates the premium that a cost-inefficient investment extracts from an investor. In this case, the AMVR indicates that an investor would be paying a premium of 331 basis points…while receiving nothing in return. Strike Three.

In the ten-year analysis, FCNKX did provide a slight positive incremental return (0.31). However, the fund was still cost-inefficient, as it did not manage to cover the fund’s incremental costs (0.42), resulting in a net loss for an investor. As the comment to Section Seven of the Uniform Prudent Investors Act states, “wasting beneficiaries, money is imprudent.”⁸

The 10-year AMVR analysis of FCNKX provides further evidence of why fiduciaries should always calculate a fund’s incremental costs using Miller’s Active Expense Ratio, as it factors in the correlation of returns between two investments to provide a more realistic evaluation of an investment’s value-added benefit, or lack thereof. In this case, the AER calculates that FCNKX is providing approximately 12.50 percent of active management. Factoring in the implicit AER expense ratio (3.36) would result in an investor suffering a projected loss of approximately 56 percent in their end-return over a twenty-year period.

In this case, since the fund did produce a positive risk-adjusted return, we can calculate an AMVR score using the Vanguard Large Cap Growth Index fund as a benchmark. FCNKX’s high r-squared/correlation of return (98) results in an AMVR score of (10.67) (3.31/0.31), indicating that an investor would be paying a premium of over 900 percent ((10.67-1) x 100).

It is hard to see how a plan sponsor, if confronted with such evidence, could carry the burden of proving that their choice of FCNKX as a plan investment was not imprudent. In fact, as pointed out earlier, the Second Circuit Court of Appeals has suggested as much.

The Active Expense Ratio
People frequently ask me why I use the Active Expense Ratio in the AMVR. Their question basically asks why plan sponsors, trustees, RIAs and other fiduciaries never mention the AER if it is so meaingful and important.

The answer is simply that the combination of the AMVR and the AER provide a level of analysis that frequently exposes the imprudence of a recommended investment in comparison to other available alternatives. Transparency is the financial and insurance industries’ kryptonite. Prove it to yourself by asking them to provide you with an AMVR exactly as shown herein.

I had one follower do just that. He reported that the plan adviser came back with a modified version of the AMVR which he claimed were “improvements.” The follower spotted the attempt to conceal the imprudence of the adviser’s recommendations. A framed copy of the follower’s polite note sits proudly on my desk.

Ross Miller, the creator of the Active Expense Ratio metric, summed up the value of the AER 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

By separating the relative costs of passive management and investment management, then calculating the amount of active management contributed by the actively managed fund, a fiduciary can derive the implicit cost of the active management provided by the actively managed fund. The higher an actively managed fund’s r-squared/correlation of returns to a comparable index fund and/or the higher the active fund’s incremental cost relative to the comparable index fund, the higher the actively managed fund’s AMVR score, cost-inefficiency, and legal imprudence. This is just the type of transparency the investment and insurance industries try to avoid, as they consistently oppose any type of true fiduciary standard requiring full and honest disclosure in making investment recommendations.

Going Forward
Being a pack rat has its benefits. In researching my files for this post, I ran across this valuable reminder from a TIAA-CREF publication entitled “Assessing Reasonableness of 403(b) Retirement Plan Fees”:

Plan sponsors are required to look beyond fees and determine whether the plan is receiving value for the fees paid.

Based on my experience, the AMVR suggests that the overwhelming majority of 401(k) and 403(b) plans and plan participants are not receiving value when compared to available investment alternatives, true alternatives under an open architecture platform. Plan sponsors can, and should, perform an objective fiduciary prudence audit using both the AMVR and the AER.

This is especially true since there are currently two cases pending in the federal appellate court that essentially address the

Whether, in an action for fiduciary breach under [ERISA], once the
plaintiff establishes a breach and a related plan loss, the burden
shifts to the fiduciary to prove that the loss is not attributable
to the fiduciary’s breach.¹⁰

As the DOL’s amicus brief mentions, the common law of trusts supports the position that the burden of proof on causation properly belongs to the plan sponsor/fiduciary. The majority of the federal Circuit Courts of Appeals agree, as does the Solicitor General of the United States. SCOTUS has already recognized that the Restatement is a respected resource that the courts often look to in resolving fiduciary issues.

Therefore, one can legitimately argue that very soon the courts will be required to shift the burden of proof on causation to plan sponsor once the plan participants establish the breach and resulting loss. The evidence presented herein suggests that that will be a burden many plan sponsors are unable to fulfill.

Enjoy the 4th!

Notes
1. Department of Labor amicus brief in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022) (Amicus Brief), 10. https://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
2. Amicus Brief, 10.
3. Amicus Brief, 13.
4. Amicus Brief, 14.
5. Amicus Brief, 24.
6. Amicus Brief, 26.
7. Amicus Brief, 24.
8. Uniform Prudent Investor Act (UPIA), Section 7 (Introduction).
9. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926.
10. Amicus Brief, 2.

Copyright InvestSense, LLC 2023. 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.

Is the Exxon Model the Future of ERISA Fiduciary Prudence?

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

“Living is easy with eyes closed
Misunderstanding all you see…”
“Strawberry Fields Forever” – The Beatles

In my role as a fiduciary risk management counsel, I constantly see plan sponsors and other investment fiduciaries exposing themselves to unnecessary liability exposure simply because they do not truly understand what their fiduciary duties. A perfect example is the current situation with the annuity industry promoting, in some cases reportedly misleading plan sponsors, on the inclusion of annuities in 401(k) and 403(b) plans.

ERISA does not require a plan to offer annuities within a 401(k) or 493(b) plan. In fact, Section 404 of ERISA does not expressly require a plan to offer any specific type of investment option. Section 404 simply requires each investment option offered within a plan to be prudent.

(a) Prudent man standard of care

(1) [A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and—
(A) for the exclusive purpose of:
(i) providing benefits to participants and their beneficiaries; and
(ii) defraying reasonable expenses of administering the plan;
(B) 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;

Some of my clients report that some annuity advocates have stated that plan sponsors have a moral duty to offer annuities within a plan. Simply not true.

I am on record as saying that I believe that the next 12-18 months is going to dramatic changes in the area of 401(k) and 403(b) litigation, with increased litigation between plan sponsors plan participants, well as between plan sponsors and plan advisers. The first signs appeared in connection with the First Circuit Court of Appeals’ Brotherston case¹, in the form of both the decision itself and the Solicitor General’s amicus brief² that was filed with SCOTUS when Putnam Investments asked the Court to review the case.

I have written several lengthy posts analyzing both the decision and the Solicitor General’s amicus brief. In short, both the First Circuit and the Solicitor General agreed that (1) the burden of proof as to the causation of losses in 401(k) litigation belongs to the plan sponsor, not the plan participants, and (2) that index funds and market indices can be used as comparators in 401(k) litigation in computing losses/damages sustained by plan participants.

The Department of Labor (DOL) recently filed an amicus brief in a pending 401(k) case.³ Citing the common law of trusts, the DOL agreed with both the First Circuit and the Solicitor General as to which party bears the burden of proof on the issue of causation in 401(k) litigation. The DOL further argued that that position is currently the prevailing opinion in the majority of the federal circuits.. The DOL’s position could play a significant role in deciding both the Home Depot and the Matney cases, both of which are currently pending in federal courts.

ERISA Plaintiff’s Exhibit A
As I tell all my fiduciary risk management clients and ERISA plaintiff attorneys, the key to fiduciary prudence is to focus on cost-efficiency, not on the active/passive debate. A friend and colleague of mine, Preston McSwain of Fiduciary Wealth Partner, recently sent me a link to a YouTube video that he thought I would find interesting, The video, “Greenwich Roundtable-Pure Passive: Risks and Rewards,” features the former CIO of Exxon’s $30 billion defined benefit plan. He explains how and why the plan switched to an all-index funds approach and how it benefitted both the company and the plan participants.

A couple of years ago, I created a simple metric, the Active Management Value Ratio^TM (AMVR). The AMVR allows fiduciaries, investors, and attorneys to quickly and easily evaluate the cost-efficiency of an actively managed fund. The AMVR is based on the research of well-respected investment experts such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, Burton G. Malkiel, and Ross Miller.

The video provides further evidence of the importance of cost-efficiency in satisfying a plan sponsor’s fiduciary duty of prudence and how easy it is to achieve using only index funds. The AMVR makes it even easier for plan sponsors to comply with their fiduciary duty of prudence, as explained here and here.

Going Forward
With the DOL’s recent amicus brief, I firmly believe that the question as to the burden of proof on the issue of causation of losses shifting to plan sponsors is not a question of “if,” but rather “when.” I believe that SCOTUS will eventually be called on to decide on one consistent standard on the issue so that the rights and protections guaranteed under ERISA will be uniformly applied in the legal system. At that point, it will be extremely difficult for plan sponsors to justify the use of cost-inefficient actively managed funds.

As Judge Kayatta noted in the Brotherston decision, plan sponsors should choose index funds if they wish to avoid unnecessary liability exposure, he was simply telling the truth. Judge Kayatta’s position has been consistently supported by studies on the cost-efficiency of actively managed funds, studies with findings such as

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.⁴  

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.⁵

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁶

[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.⁷

Judge Kayatta’s position is further supported by John Langbein, who served as the Reporter on the committee that wrote the Restatement (Second) of Trusts over fifty years ago. Shortly after the release of the revised Restatement, Langbein wrote a law review article on the new Restatement. At the end of the article, he made a bold prediction:

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.⁸   

I would suggest that that time is here and that the Greenwich Roundtable video shows how and why index funds will be the applicable standard for prudent plan sponsors and other investment fiduciaries. The question right now for plan sponsors and other investment fiduciaries is whether they will be able to carry the burden of proof as to causation of damages, whether they will be able to prove that their choices did not cause any losses suffered by a plan’s participants. The prudent plan sponsor will promptly audit their plans using the AMVR to determine the extent of any potential liability – and whether Exxon’s all-index fund strategy should be considered.

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
2. https://www.justice.gov/osg/brief/putnam-invs-llc-v-brotherston
3. https://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
4. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
5. 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. 
6. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
7. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
8. 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

Copyright InvestSense, LLC 2023. 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.

Interpreting the DOL’s Amicus Brief and its Potential Impact on the Future of 401(k) Litigation

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

Whenever I meet with a prospective new client, I first explain InvestSense’s “401(k) Fiduciary Prudence Circle,” (FP Circle), one of the cornerstones of our “Fiduciary InvestSense™” process. ERISA and the courts analyze a fiduciary’s decisions in terms of the process used by a plan sponsor in selecting investment options for a plan, not in terms of the ultimate performance of the investment options chosen. The combination of the FP Circle and the Active Management Value Ratio™ (AMVR) provide evidence of both the use of a meaningful process and the compliance of same with applicable legal standards.

We also educate the prospective client on some 401(k)/403(b) fiduciary risk management issues that other consultants usually do not cover. The two AMVR slides below illustrate one of our presentations involving Fidelity Contrafund, a fund found in many defined contribution plans.

The first slide is an AMVR analysis comparing Fidelity Contafund K shares (FCNKX) and the Fidelity Large Cap Growth Fund (FSPGX). Designed to compete with comparable Vanguard funds, FSPGX has done so, both in terms of returns and overall cost efficiency. The issue for plan sponsors is that FSPGX has outperformed FCNKX as well.  FSPGX is clearly a more cost-efficient investment option for fiduciaries than FCNKX.

The problem is that Fidelity does not make FSPGX available to defined contribution plans. As a result, plans seemingly settle for FCNKX, despite the obvious fiduciary liability issues due to FCNKX’s comparative cost-inefficiency when compared to other available investment options.

The slide below is an AMVR analysis comparing Fidelity Contafund K shares (FCNKX) and Vanguard’s Large Cap Growth Index Fund Admiral shares (VIGAX). Plans often use Vanguard’s Admiral shares and institutional shares interchangeably given their similarities in terms of cost and performance.

One again, just as with FSPGX, FCNKX proves to be cost-efficient relative to VIGAX. The cost-inefficiency of FCNKX become even worse when Miller’s Active Expense Ratio is used instead of FCNKX’s nominal cost numbers, as shown in the “AER” column.

The need for plans to address these fiduciary prudence and cost-inefficiency issues has become even more important in light of a recent amicus brief filed by the DOL (DOL brief) addressing the issue of which party has the burden of proof with regard to the issue of causation of damages in 401(k)/403(b) litigation. While there is a split within the federal courts on this issue, the DOL’s brief provides a persuasive argument that the burden of proof belongs to plan sponsors, not plan participants.

One of the most persuasive arguments made in support of this position, both in terms of courts decisions and the DOL’s brief, has been that since the legal focus is necessarily on the process used by a plan in making decisions on the plan’s investment options, such information is exclusively within the possession of the plan. This is why the law has consistently stated that plaintiffs are not required to plead a party’s mental processes or state of mind and why the law allows circumstantial evidence to establish same.

Plan sponsors should take note of and review their plans in light of two statements in the DOL’s brief concerning causation of damages:

In short, [a plan sponsor] would have to prove ‘that a prudent fiduciary would have made the same decision.’

If a plaintiff succeeds in showing that ‘no prudent fiduciary’ would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to ‘shift’ to the fiduciary defendant.

As the AMVR slides herein demonstrate, the AMVR can be easily used to establish the relative cost-inefficiency, and, thus, the relative imprudence of an actively managed mutual fund. As a result, if, as expected, SCOTUS eventually rules that the burden of proof on the issue of causation does “shift” to the plan sponsor, that burden might prove to be a very difficult burden to satisfy in many cases.

For further information on the AMVR, click here.

Fiduciary InvestSense™: Annuities, Plan Sponsors, and Fiduciary Law

By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

As an attorney and a fiduciary risk management consultant, my job is to protect plan sponsors, trustees, and other investment fiduciaries against unnecessary fiduciary liability…and themselves. Far too often, I find that 401(k) and 403(b) plan sponsors are their own worst enemy. As that great philosopher, Pogo, once said, “we have met the enemy, and he is us.”

I have spent the last 27+ years involved in some way or the other with fiduciary law. The one constant has been the evidence that plan sponsors and other investment fiduciaries do not truly understand what their fiduciary responsibilities do, and do not, require them to do.

As a result, I am often contacted by fiduciaries with questions about fiduciary law, including requests for information on how to extricate themselves from a fiduciary-related legal predicament. As I tell my fiduciary risk management clients, the best strategy for avoiding risk is to avoid it altogether whenever possible. And that is the situation that many plan sponsors are facing with regard to deciding whether to include annuities in their 401(k) and 403(b) plans.

The two fiduciary duties most often cited in 401(k) and 403(b) litigation are the duties of prudence and loyalty

We have explained that the fiduciary duties enumerated in § 404(a)(1) have three components. The first element is a “duty of loyalty” pursuant to which “all decisions regarding an ERISA plan `must be made with an eye single to the interests of the participants and beneficiaries.’” Second, ERISA imposes a “prudent man” obligation, which is “an unwavering duty” to act both “as a prudent person would act in a similar situation” and “with single-minded devotion” to those same plan participants and beneficiaries.¹

Finally, an ERISA fiduciary must “`act for the exclusive purpose‘” of providing benefits to plan beneficiaries.² (emphasis added)

I believe in the KISS philosophy – Keep It Simple & Smart. To that end, I have a simple process that I recommend that plan sponsors use to resolve such matters. I suggest that they ask themselves these two questions:

1. Does ERISA or any other law expressly require that the investment be included in the plan?

2. Would/Could inclusion of the investment in the plan potentially expose the plan and plan sponsor to unnecessary fiduciary liability exposure?

Smart, enlightened plan sponsors will continue to refuse to offer annuities, in any form, within their plans. Why?

• With regard to annuities and the first question, neither ERISA nor any other law expressly requires plan sponsors to offer annuities or any other any specific type of investment product within a plan.
  
• With regard to the second question, neither ERISA nor any other law requires plan sponsors to voluntarily expose themselves to unnecessary fiduciary risk liability. Annuities present genuine fiduciary liability issues, despite the annuity industry’s ongoing refusal to acknowledge and address such issues.

Whenever there is any talk about the enactment of a true fiduciary standard to cover the financial services industry, the industry immediately threatens legal action to block such legislation, with the usual claim of seeking preservation of choice for plan participants. Advocates for a meaningful fiduciary standard typically counter by pointing out that (1) legally imprudent investment products do not constitute a meaningful “choice” for plan participants, and (2) the “choice” argument is, in reality, an attempt to cover up the fact that there are genuine questions as to whether annuities could ever qualify as a prudent investment under a true fiduciary standard. As discussed herein, the evidence suggests that due to the way that they are presently structured, few, if any, annuities could meet a true fiduciary standard

SECURE 2.0 created a “safe-harbor” from liability for plan sponsors who chose to include annuities within their plan, only to have the annuity issuer default on the payments required under the annuity. SECURE 2.0 failed to provide similar protections for plan participants who suffer losses in such circumstances.

The pro-annuity provisions of SECURE 2.0 remind me of the court’s words in Hirshberg & Norris v. SEC, where the court rejected the defendant’s suggestion that the securities laws were intended to protect the investment industry, the court stating that

[t]o accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protection of the broker-dealer rather than for the protection of the public. On the contrary, it has long been recognized by the federal courts that the investing and usually naive public need special protection in this specialized field.³

Replace the reference to “securities” with “ERISA” and “broker-dealers” with “annuity industry” and I believe the court’s words are equally applicable to the current situation facing plan sponsors, as annuity salesmen try to convince them to include annuities in their plans.

The annuity industry continually bemoans the fact that they cannot get more plan sponsors, and investment fiduciaries in general, to offer annuities. I talk to plan sponsors on a regular basis and the story on their reluctance to offer annuities is generally some variation of the following:

• Distrust of the annuity industry due to (1) the perceived lack of full and meaningful disclosure, and (2) the refusal of the annuity industry to acknowledge and address the genuine fiduciary liability issues that plan sponsors face due to design and overall complexity issues with annuities.
• The impact of the costs and fees typically associated with annuities, resulting in a potential breach of a plan sponsor’s duty of prudence. While annuity advocates often play a game of semantics, stating that annuities doe do charge “fees,” the reality is that annuities often have significant “costs” which are “hidden” in an annuity’s “spread.” Furthermore, such spreads, often 1-2 percent, or more, are taken prior to the annuity issuer calculating the amount of interest to be credited to the annuity owner, raising genuine potential fiduciary breach issues for plan sponsors including them in a plan.
• The difficulty and/or inability of plan sponsors to perform the legally independent investigation and evaluation of a product required by ERISA. The courts have warned plan sponsors that reliance on commissioned salespeople for advice is not legally reasonable or justifiable due to the inherent conflicts of interest in such situations.
• The frequent inclusion of certain complicated and confusing provisions within annuity contracts that protect the annuity issuer’s interests at the expense of an annuity owner’s expense, resulting in a breach of a plan sponsor’s duties of loyalty and prudence.
• The frequent inclusion of certain provisions within annuity contracts that require the annuity owner to surrender ownership and control over both the annuity contract and the accumulated value of the contract, with no guarantee of a commensurate return for the plan participant, in order for the annuity owner to receive the “guaranteed income for life” benefit. This scenario could potentially result in a windfall for the annuity issuer at the plan participant’s expense, a clear breach of a plan sponsor’s duties of loyalty and prudence.

Chris Tobe, one of my fellow co-founders on “The CommonSense 401(k) Project” has written extensively on a number of factors that generally result in annuities being a liability trap for fiduciaries. Two of the primary factors Chris cites are the single entity credit risk and illiquidity issues associated with annuities. Chris has extensive experience in the design and analysis of annuities. Plan sponsors should read Chris’ excellent analyses.

A full and complete analysis of the analysis is beyond the scope of this post. At the end of thois post I have included a list of various studies and other resources that I recommend to all of my fiduciary risk management clients. I highly recommend that plan sponsors invest the time to read these resources in order to understand the potential liability “traps” inherent in annuities.

Indexed Annuities
There are several passages in particular that I feel summarize the key legal fiduciary liability issues thatt annuities present, passages that support the distrust issues that plan sponsors and other investment fiduciaries often mention to me. Equity-indexed annuities are currently a popular form of annuities. Dr. William Reichenstein is a well-respected expert in financial services. Dr. Reichenstein has authored several articles on the financial inefficiency of equity-indexed annuities. Among his findings and conclusions:

Indexed annuities (IA) including equity indexed annuities (EIAs) are complex investment contracts. (citing features such as surrender penalties; an annuity’s “spread;” arbitrary restrictions on returns that owners can actually achieve, e.g., caps and participation rates, and ability to reset same on a regular basis and on such terms at the annuity issuer desires; market value adjusted options penalizing an annuity owner who withdraws money from an annuity before term, various interest crediting methods and potential interest forfeiture rules e.g., annual reset, point-to-point, or high water point; potential interest forfeiture rules; the issue of averaging and they type of averaging used.⁴

More important, because of their design, index annuities must underperform returns on similar risk portfolios of Treasury’s and index funds. EIAs impose several risks that are not present in market-based investments including surrender fees and loss of return on funds withdrawn before the end of the term. This research suggests that salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.⁵

The interest credited on an EIA is based on the price index. So, the investor may get part of the price appreciation, but she does not receive any dividends associated with the underlying stock index. The return may be further reduced based on participation rate, spread, and cap rate. Moreover, the insurance firm almost always has the ability to adjust at its discretion the participation rate, spread, or cap rate at the beginning of each term.⁶

When annuity advocates questioned his findings, Reichenstein provided a follow-up paper responding to the advocates’ criticisms as follows:

I concluded that because of their structure “all indexed annuities must produce below-market, risk-adjusted returns.”⁷

As discussed by Reilly and Brown (2009, p. 549), to try to add value compared with a passive investment strategy, active managers use one of three generic themes: (1) market timing; (2) overweighing stocks by sectors/ industries, overweighing value or growth stocks, or overweighing stocks by size; and (3) through security selection. All attempts to beat a market index on a risk-adjusted basis use one or more of these three themes. By design, indexed annuities cannot add value with any of these themes.⁸

By design, (1) they do not attempt market timing, (2) they do not make sector/industry/ style/size bets, and (3) they do not try to add value through security selection. Furthermore, because hedging strategies usually require long and short positions in options contracts, the industry cannot argue that indexed annuity strategies beat the market because option values are consistently undervalued or overvalued. So, I concluded that the risk-adjusted returns on indexed annuities must trail the risk-adjusted returns available in marketable securities by the sum of their spread plus their transaction costs.⁹

In short, because of their design, indexed annuities cannot add value to offset their substantial embedded costs.¹⁰

In support of his argument, Reichenstein referenced a study by two-well respected members of the financial services community, Nobel laureates Eugene Fama and Kenneth French  Fama and French cited the research of Dr. William F. Sharpe and the arithmetic of equilibrium accounting, declaring that

To put this argument in the context of indexed annuities, we do not need empirical tests to ensure that IAs underperform their risk-adjusted benchmark portfolio’s returns. Because their structure prevents them from adding value compared to this benchmark return, they must underperform this benchmark return by the sum of their spread plus their transaction costs.¹¹

McCann and Luo studied equity-indexed annuities and best summarized my opinion toward equity-indexed annuities in the context of fiduciary risk management:

[The] net result of equity-indexed annuities’ complex formulas and hidden costs is that they survive as the most confiscatory investments sold to retail investors.¹²

Terry and Elder analyzed Reichenstein’s research and offered the findings of their own research on equity-indexed annuities.

[Reichenstein’s] essential point is that indexed annuities are simply repackaging returns that are already available to investors in the market place without adding any potential security selection or market timing value. The cost of this repackaging is the ‘spread.’ In summary, the simple economics of [equity-indexed annuities] is that investors are paying 2-3% annually in investor spreads to receive returns similar to those already available in the market, trivial insurance benefits, and to receive a no loss guarantee.¹³

Insurance companies [typically reserve] the option of changing many of the {index annuity’s] contract features after the first year. In particular they change the participation rates, spreads, and cap rates to maintain their investment spreads.” In other words, annuity issuers reserve the right to reduce the annuity’s owner’s return in order to maintain their investment spread.¹⁴

The opportunity costs of investing in [indexed annuities] over long horizons compared with reasonable and implementable alternative strategies are quite high….{A]t a minimum, these opportunity costs should be disclosed to potential  investors at time of purchase.¹⁵

I believe the same sentiments are equally applicable to fiduciary responsibilities with regard to 401(k) and 403(b) plan and provide valuable risk management advice for plan sponsors with regard to equity-indexed annuities.

John Olson, a respected expert on annuities, provided an excellent summary on the key issues involving index annuities:

Owners of index annuities will almost never receive the full amount of gain that was realized by the index chosen. That is because there is rarely enough money left over after buying the bonds required to back the contractual guarantees to buy enough options on the index to get the full amount of any gain in that index. This is one reason why it is not true that an index annuity owner gets the upside of the market with no downside risk. At best, he or she will receive only a portion of index gain, both because the insurer could not buy enough option to get that full gain and because many index annuities limit the amount of index-linked interest that it will credit. (It does so because the specialized call options it purchases are themselves limited by a cap, allowing the insurer to purchase more upside potential than it could without such a cap.)¹⁶

Olson’s paper addresses several myth and misconception about index annuities, including Olson refuting the annuity industry’s popular “cannot lose money-no risk” claim.

It is possible–if one withdraws money from or cash (sic) in the contract during the surrender charge period. While some contracts have a genuine guarantee of principal (surrender charges my wipe out interest earned but not the money contributed in premiums) that preserves premium even in the early contract years, most do not. That said, negative performance in the chosen index or indices will not erode the contract’s cash value Thus, previously credited interest cannot be lost due to bad index performance.¹⁷

Remember the point regarding the plan sponsor’s fiduciary responsibilities on the ability to determine and analyze the interest crediting method utilized by a annuity issuer? As previously notes, the courts have warned plan sponsors that reliance on commissioned salespeople does meet the “reasonable reliance” requirement for hiring experts.

Variable Annuities
A second type of annuity sometimes appearing in 401(k) and 403(b) plans is variable annuities (VAs). I have previously written on both this blog and my “CommonSense InvestSense” blog about the potential liability issues involved with variable annuities. The “CommonSense InvestSense” blog is more directed toward on individual investors.

Over the ten-plus years that I have written the “CommonSense InvestSense” blog, one post in particular has generated the most responses, “Variable Annuities: Reading Between the Marketing Lines.” I continue to get people thanking me for an objective and plain-English explanation of an otherwise complex product. More rewarding was the fact that most people told me that the article persuaded them to avoid variable annuities altogether.

As with equity-indexed annuities, I believe that variable annuities are fiduciary liability “traps.” Interestingly enough, some insurance executives share the same concerns.

Again, a full and complete discussion and analysis is beyond the scope of this post. The purpose of this post is to hopefully raise awareness of genuine fiduciary liability issues inherent with annuities and the need for plan sponsors to consider such issues.

The three most concerning issues from a fiduciary liability standpoint are (1) the use of “inverse pricing” often used in calculating a VA’s annual M&E/death benefit fee, (2) the cost-inefficiency of many of the investment sub-accounts offered with the VA, and (3) the fact that equity-indexed annuities are typically structured in such a way as to promote a windfall for the annuity issuer at the annuity owner’s expense. This inequitable situation results when annuities condition the receipt of the alleged benefit, “guaranteed income for life,” on the annuity owner surrendering both the annuity contract and the accumulated value within the VA to the annuity issuer, with no guarantee that the annuity owner will receive a commensurate return.

I refer you to my “CommonSense InvestSense” blog post for a more complete analysis of the legal liability issues involved with VAs.

For this post, I just want to touch on three common sales pitches used in VA sales so that plan sponsors can recognize and avoid them.

1. Annuity owners do not pay a sales charge, so more of their money goes to work for them.

The statement that variable annuity owners pay no sales charges, while technically correct, is misleading. Variable annuity salespeople do receive a commission for each variable annuity they sell, such commission usually being a percentage of the total amount invested in the variable annuity.

While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through a variable annuity’s various fees and charges, particularly the M&E charge.

To ensure that the cost of commissions paid is recovered, the insurance company typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for an initial surrender charge for withdrawals during the first year, decreasing 1 percent each subsequent year thereafter until the surrender charges end. There are some surrender charge schedules that charge a flat rate over the entire surrender charge period.

2. The inherent value of the VA’s death benefit is highly questionable and often grossly excessive.

[T]he fee [for the death benefit] is included in the so-called Mortality and Expense (M&E) risk charge. The M&E risk charge is a perpetual fee that is deducted from the underlying assets in the VA, above and beyond any fund expenses that would normally be paid for the services of managed money.¹⁸

[T]he authors conclude that a simple return of premium death benefit is worth between one to ten basis points, depending on purchase age. In contrast to this number, the insurance industry is charging a median Mortality and Expense risk charge of 115 basis points, although the numbers do vary widely for different companies and policies.¹⁹

The authors conclude that a typical 50-year-old male (female) who purchases a variable annuity—with a simple return of premium guaranty—should be charged no more than 3.5 (2.0) basis points per year in exchange for this stochastic-maturity put option. In the event of a 5 percent rising-floor guaranty, the fair premium rises to 20 (11) basis points. However, Morningstar indicates that the insurance industry is charging a median M&E risk fee of 115 basis points per year, which is approximately five to ten times the most optimistic estimate of the economic value of the guaranty.²⁰

Excessive and unnecessary costs violate the fiduciary duty of prudence. The value of a VA’s death benefit is even more questionable given the historic performance of the stock market. As a result, it is unlikely that a VA owner would ever need the death benefit. These two points have resulted in some critics of VAs to claim that a VA owner needs the death benefit like a duck needs a paddle.”

3. The “inverse pricing” method used by many VAs is inequitable.

VA advocates tout various benefits. Anyone considering a VA should also consider the question-“at what cost?” VAs often calculate a VA’s annual M&E charge/death benefit based on the accumulated value within the VA, even though contractually they typically limit their legal liability under the death benefit to the VA owner’s actual investment in the VA.

As a result, over time, it is reasonable to expect that the accumulated value within the VA will significantly exceed the VA owner’s actual investment in the VA. This method of calculating the annual M&E, known as “inverse pricing,” results in a VA issuer receiving a windfall equal to the difference in the fee collected and the VA issuer’s actual costs of covering their legal liability under the death benefit guarantee.

As mentioned earlier, fiduciary law is a combination of trust, agency, and equity law. A basic principle of equity law is that “equity abhors a windfall.” The fact that VA issuers knowingly use the inequitable inverse pricing method to benefit themselves at the VA owner’s expense results in a fiduciary breach for fiduciaries who recommend, sell or use VAs in their practices or in their pension plans.

The industry is well aware of this inequitable and counter-intuitive situation. John D. Johns, a CEO of an insurance company, addressed these issues in an article entitled “The Case for Change.”

Another issue is that the cost of these protection features is generally not based on the protection provided by the feature at any given time, but rather linked to the VA’s account value. This means the cost of the feature will increase along with the account value. So over time, as equities appreciate, these asset-based benefit charges may offer declining protection at an increasing cost. This inverse pricing phenomenon seems illogical, and arguably, benefit features structured in this fashion aren’t the most efficient way to provide desired protection to long-term VA holders. When measured in basis points, such fees may not seem to matter much. But over the long term, these charges may have a meaningful impact on an annuity’s performance.²¹

In other words, inverse pricing is always a breach of a fiduciary’s duties of both loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without any commensurate return, which also violates Section 205 of the Restatement of Contracts.

In other words, the use of inverse pricing is always a breach of a fiduciary’s duties of loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without a commensurate return, which also violates Section 205 of the Restatement of Contracts.

Going Forward
As shown herein, annuities have the ability to raise genuine fiduciary liability issues for plan sponsors. Those issues may become even more problematic for plan sponsors in the near future in connection with 401(k)/403(b) litigation. While some federal courts are already placing the burden of proof regarding causation of damages on plan sponsors, there is still a split in the federal courts.

There is currently a case, Matney v. Briggs Gold of North America²², which will seemingly force the legal system, most likely the Supreme Court, to establish one consistent standard for courta in 401(k)/403(b) actions. Given the fact that the First Circuit Court of Appeals and other federal circuits, the United States Solicitor General, and more recently the Department of Labor have expressed support for shifting said burden of proof to plan sponsors, the likelihood is that the Supreme Court would follow suit and rule in favor of such a policy, especially since it is consistent with the common law of trusts.

In talking with my clients about the issue of annuities in 401(k) and 403(b) plans, I ask them whether they will be able to carry the burden of proof as to causation, be able to calculate and verify the guaranteed benefits such as the interest crediting payments received within such annuities to ensure both the prudence of the products and that a plan participant’s ERISA rights are not being violated.

Similarly, will a plan sponsor be able to determine which index interest crediting model is in a plan participant’s best interests, e.g., one year annual reset, multiple year point to point, one-year monthly cap index, one-year averaged monthly? Will plan sponsors be able to determine whether the index used in such indexed annuities is legitimate and in the plan participants’ best interests? Suddenly, the simplicity of index funds is looking better and better.

Plan sponsors, and investment fiduciaries in general, need to understand the significant, and irreconcilable differences, between the insurance/ annuity industry model and the ERISA/fiduciary law model. The insurance/ annuity industry is all about managing the odds, managing risk in such a way to ensure that the odds are in their favor, that their best interests take precedence over those of their customers, that losses are offset by gains to ensure their overall profitability.

ERISA and fiduciary law is just the opposite, the focus being on equity, fundamental fairness, and certainty, always acting in such a way that the plan participant’s best interests are best served. With fiduciary law, the fiduciary gets one chance to “get it right,” there are no “mulligans” or do-overs. Furthermore, the recent SCOTU’ and Seventh Circuit Hughes²³ decisions clearly establish that the concept of offsets is not recognized under ERISA/fiduciary law.

One can legitimately argue that the basic concept and structure of an annuity is the anti-thesis of fiduciary law and equitable principles. Conditioning an annuity owner’s receipt of the advertised benefits of “guaranteed income for life,” with “no investment losses,” upon the annuity owner’s surrendering both the control and ownership of both the annuity contract and the accumulated value within the annuity, without any guarantee of receiving a commensurate return, is not only fundamentally unfair and inequitable, but clearly inconsistent with both the fiduciary duty of prudence and loyalty, as it increases the odds of a windfall in favor of the annuity issuer at the annuity owner’s expense. “Equity abhors a windfall is a basic tenet of equity law, which is basic component of fiduciary law.

The typical response of annuity advocates to such criticism-that annuity owners can purchase a rider to ensure the return of their principal-does not satisfy such fiduciary law and liability concerns and only serves to further reduce the annuity’s owner’s effective end-return. Both the Department of Labor and the General Accountability Office have noted that each additional 1 percent in fees/costs reduces an investor’s end-return by approximately 17 percent over a 20-year period.²⁴

There is a familiar expression in the investment and annuity industries-“sell the sizzle, not the steak.” That describes the marketing strategy typically used by the annuity industry, with the “guaranteed income for life” and “no risk” spiels being the “sizzle.” The inequities aspects of annuties discussed herein, inequities designed to serve the best interests of the annuity issuer, not the annuity owner, are obviously the “steak.”

Fiduciary investment risk management 101-Keep It Simple & Smart. Once again, the best strategy for avoiding unnecessary fiduciary investment risk is to avoid it altogether whenever possible. Neither ERISA nor any other law expressly requires plan sponsors to offer annuities within a 401(k) or 403(b) plan. Plan participants desiring to purchase an annuity are free to do so outside the plan, without exposing the plan sponsor to any unnecessary fiduciary liability risk.

Notes
1. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003). (Gregg)
2. Gregg, 841-842.
3. 117 F.2d 228, 233 (1949).
4. Reichenstein, W. (2009) Financial analysis of equity indexed annuities. Financial Services Review, 18, 291-311, 291 (Reichenstein I)
5. Reichenstein I, 291.
6. Reichenstein I, 298.
7. Reichenstein, W. (2011) Can annuities offer competitive returns? Journal of Financial Planning, 24, 36. (Reichenstein II)
8. Reichenstein II, 36.
9. Reichenstein II, 36.
10. Reichenstein II, 36-37.
11. Fama, E. F. & French, K. R. (2009) Why Active Investing Is a Negative Sum Game, (available at http://www.dimensional.com/famafrench/2009/06/why-active-investing-is-a-negative-sum-game.html)
12. McCann, C. & Luo, D. (2006) An Overview of Equity-Indexed Annuities. Working Paper, Securities Litigation and Consulting Group (McCain & Luo
13. Terry, A. & Elder, E. (2015) A further examination of equity-indexed annuities. 24, 411-428, 416. (Terry & Elder)
14. Terry & Elder, 419.
15. Terry & Elder, 427.
16. Olson, J. (November 2017) Index Annuities: Looking Under the Hood. Journal of Financial Services Professionals. 65-73, 71,
17. Olson, 72.
18. Milevsky, M. &  Posner, S. The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126, 92. (Milevsky & Posner)
19. Milevsky & Posner, 92.
20. Milevsky & Posner, 92.
21. Johns, J. D. (September 2004) The Case for Change, Financial Planning 158-168, 158. (Johns)
22. Matney v. Briggs Gold of North America, No. 4045 (10th Cir. 2022)
23. Hughes v. Northwestern University, No. 18-2569, March 23, 2023 (7th Cir. 2023); Hughes v. Northwestern University, 142 S.Ct. 737 (2022)
24. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (“DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”).

Recommended Reading
Collins, P.J., Lam, H., & Stampfi, J. (2009) Equity indexed annuities: Downside protection, but at what cost? Journal of Financial Planning, 22, 48-57.

FINRA Investor Insights (2022) The Complicated Risks and Rewards of Indexed Annuties  The Complicated Risks and Rewards of Indexed Annuities | FINRA.org

Fama, E. F. & French, K. R. (2009) Why Active Investing Is a Negative Sum Game, (available at http://www.dimensional.com/famafrench)

FINRA Investor Alert (2003) Variable Annuities: Beyond the Hard Sell

Frank, L., Mitchell, J. & Pfau, W. Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios, Journal of Financial Planning, April 2014, 38-47. 

Katt, P. (November 2006) The Good, Bad, and Ugly of Annuities AAII Journal, 34-39.

Lewis, W. Chris. 2005. A Return-Risk Evaluation of an Indexed Annuity Investment.” Journal of Wealth Management 7, 4.

McCann, C. & Luo, D. (2006). An Overview of Equity-Indexed Annuities. Working Paper, Securities Litigation and Consulting Group.

Milevsky, M. & Posner, S. The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126.

Olson, J. Index Annuities: Looking Under the Hood. Journal of Financial Services Professionals. 65-73 (November 2017),

Reichenstein, W. Financial analysis of equity-indexed annuities. Financial Services Review, 18 (2009) 291-311.

Reichenstein, W. (2011), Can annuities offer competitive returns? Journal of Financial Planning, 24, 36.

Securities and Exchange Commission. (2008) Investor Alerts and Bulletins: Indexed Annuties SEC.gov | Updated Investor Bulletin: Indexed Annuities

Sharpe, W.F. (1991) The arithmetic of active management. Financial Analysts Journal, 47, 7-9.

Terry, A. & Elder, E. (2015) A further examination of equity-indexed annuities. 24, 411-428.

The Active Expense Ratio: Fiduciary Risk Management’s “Little Secret”

By James W. Watkins, J.D., CFP Board Emeritus™, AWMA®

When I created the Active Management Value Ratio (AMVR) metric, the goal was to create a simple tool that would allow investors, investment fiduciaries, and attorneys to quickly and easily evaluate the cost-efficiency and, thus, the fiduciary prudence of an actively managed mutual fund. The metric itself is based on a combination of research and concepts of investment icons such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel.

T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.⁷

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  

These three opinions formed the basis for the initial iteration of the AMVR. Further research led to the current version of the AMVR – AMVR 3.0 – which incorporates the research of Ross Miller and his Active Expense Ratio (AER) metric. Miller explains the importance of the AER 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

An example of an AMVR analysis of the retirement share of a well-known actively managed mutual fund is shown below.

An AMVR analysis can be calculated for any time period. In this case, a five-year analysis comparing an actively managed fund and a comparable index fund shows that the actively managed fund is cost-inefficient, as it fails to provide a positive incremental return (1.33), so naturally the incremental costs exceed the incremental returns. A cost-inefficient fund is an imprudent investment under the Restatement (Third) of Trusts.

The example show above is far from an anomaly. Research has consistently shown that the overwhelming majority of actively managed funds are cost-inefficient.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.⁵  

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.⁶

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁷

[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.⁸

The cost-inefficiency in the example is even more serious if measured using the AER, In this case, the high incremental costs of the funds combined with the fund’s high correlation of return to the benchmark (98) results in an AER of 5.67.

In Tibble,⁹ SCOTUS recognized the Restatement (Third) of Trusts (Restatement) as a legitimate resource in resolving fiduciary disputes, including questions regarding fiduciary duties under ERISA. The Restatement clearly recognizes the importance of cost-efficiency, stating that fiduciaries should carefully compare the costs associated with a fund, especially when considering funds with similar objectives and performance. The Restatement advises plan fiduciaries that in deciding between funds that are similar except for their costs, the fiduciary should only choose an active fund with higher costs and/or risks if

the course of action in question can reasonably be expected to compensate for its additional costs and risk,…¹⁰

Studies by both the DOL and the GAO have found that each additional one percent in fees/costs reduces an investor’s end-return by 17 percent over a 20-yeat period.¹¹ In our example, that would result in a projected loss of 45 percent using the nominal incremental cost/underperformance numbers (2.63), and 94 percent using the AER incremental cost/underperformance numbers (5.52).

The Active Expense Ratio – Fiduciary Risk Management’s “Little Secret”
Whenever I show a prospective fiduciary risk management client a sample AMVR analysis, one of the first questions is about the AER column and why is it important. Miller’s quote obviously addresses the significance of the AER.

In my last post, I referenced a similar quote in a 2007 speech from then SEC General Counsel, Brian G. Cartwright. Cartwright asked his audience to think of an investment in an actively managed mutual fund as a combination of two investments: a position in an “virtual” index fund designed to track the S&P 500 at a very low cost, and a position in a “virtual” hedge fund, taking long and short positions in various stocks. Added, together, the two virtual funds would yield the mutual fund’s real holdings.

The presence of the virtual hedge fund is, of course, why you chose active management. If there were zero holdings in the virtual hedge fund — no overweightings or underweightings — then you would have only an index fund. Indications from the academic literature suggest in many cases the virtual hedge fund is far smaller than the virtual index fund. Which means…investors in some of these … are paying the costs of active management but getting instead something that looks a lot like an overpriced index fund. So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether or not they’re getting the desired bang for their buck?¹²

The AER provides investors, investment fiduciaries, and ERISA attorneys with just the tool to provide such information. The AER for an actively managed fund can be calculated with just the actively managed fund’s r-squared information and the fund’s incremental cost data.

In the AMVR analysis above, the actively managed fund had an r-squared, or correlation of returns, number of 98. Miller then provides an equation for calculating the percentage of active management provided by the actively managed fund relative to a comparable index fund. In this case, the r-squared number of 98 equates to an implied active weight of 12.50 percent.

Over the last decade or so, it has not been uncommon for U.S. domestic equity funds to have r-squared numbers of 95 and above, resulting in relatively low active weight numbers, typically less that 25 percent. The list below shows the active weights associated with r-squared number of 95 and above.

99 > .0913
98 > .1250
97 > .1537
96 > .1695
95 > .1866

The AER is then calculated by dividing the actively managed fund’s incremental costs by the actively managed fund’s active weight number. Here, the actively managed fund’s incremental costs (0.42) divided by the fund’s active weight (.125) results in an AER score of 3.36, or seven times the actively managed fund’s publicly reported expense ratio.

Another way of combining the AMVR and the AER is to use the data to determine how you would have rationalized the imprudence of a choice of the actively managed fund in a 401(k)/403(b) action. ERISA plaintiff attorneys are increasingly using the AER in bracketing estimated damages. The argument would be given the actively managed fund significantly underperformance the comparable index fund, the index fund would have not only have provided plan participants with a significantly better return, but the incremental return would not have been incurred, thereby increasing the plan participants’ returns even more. As John Bogle was fond of saying, “Investors keep what they don’t pay for.”

Going Forward
As some courts continue to try to justify the use of cost-inefficient active funds in 401(k) plans, an often-unaddressed issue involves the fundamental issues of just how much active management do “actively” managed funds actually provide and at what cost to investors

The high correlation of returns that is being seen between U.S. domestic equity funds and comparable index funds naturally raises the question of “closet indexing.” Closet index funds tout the alleged benefits of active management and try to justify higher expenses ratios and costs on such alleged benefits.

The financial implications of closet indexing for investors are well-known.  

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….¹³ 

The AER makes plan sponsors and other investment fiduciaries address the uncomfortable question of closet indexing and the resultant cost-inefficiency and legal imprudence of such funds. The AER recognizes that a high correlation of returns between a “actively managed” fund and a comparable index fund suggests that active management is contributing little, if anything, in terms of performance and return for an investor. The AER recognizes that the combination of a high r-squared number and high incremental costs increases a fund’s implicit costs and overall cost-inefficiency.

The AER should make courts and plan sponsors realize that the implicit costs of funds that provide a low level of active management, funds with a low active weight/active contribution, are naturally going to be higher than a fund that truly provides active management. The AER raises the fundamental question of how much “active management” must a fund provide to qualify as an actively managed fund and avoid potential allegations of fraud and misrepresentation under federal securities laws.

The Department of Labor (DOL) recently filed an amicus brief in a pending 401(k) action. The significance of the amicus brief is that the DOL sided with both several other federal circuit courts of appeal and the common law in taking the position that plan sponsors, not plan participants, have the burden of proof with regard to the issue of causation in 401(k)/403(b) litigation. This issue is currently involved in two pending federal 401(k) litigations.

Now that the DOL has taken a position that is consistent with both a previous amicus brief filed with SCOTUS by the Solicitor General in the Brotherston¹⁴ case and a significant portion of the federal courts of appeal, I believe that SCOTUS will ultimately agree the burden of proof on the issues of causation shifts to the plan sponsor once the plan participants properly plead their case.

With ERISA plaintiff attorneys already incorporating the AER in calculating damages, plan sponsors need to ask themselves whether they could carry that burden of proof. I believe that the studies referenced herein, as well as the AMVR, raise genuine doubts about the ability of plan sponsor to meet that challenge. That is many of my fiduciary risk management clients are already proactively using both the AMVR and the AER to estimate and reduce the extent of any potential fiduciary liability exposure.

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. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926.
5. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
6. 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. 
7. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
9. Tibble v. Edison International, 135 S. Ct 1823 (2015).
10. Restatement (Third) Trusts (American Law Institute), cmt. h(2). All rights reserved. (Restatement)
11. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (“DOL Study”); “Private Pensions: Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (“GAO Study”).
12. SEC Speech: The Future of Securities Regulation: Philadelphia, Pennsylvania: October 24, 2007 (Brian G. Cartwright). http://www.sec.gov/news/speech/2007/spch102407bgc.htm
13. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What They Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133 (Cremers), 5, 42.
14. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018). (Brotherston)

Copyright InvestSense, LLC 2023. 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.