A Better Mousetrap?: A New Format for Plaintiffs’ Complaints in ERISA Fiduciary Breach/Excessive Fee Cases?

My two most recent posts on this blog have dealt with recent decisions involving ERISA fiduciary breach cases alleging excessive fees in 401(k) plans. To avoid a possible false sense of security within the investment industry, the posts also discussed provisions within the Restatement (Third) Trusts (Restatement) that might provide a means for plaintiffs counsel to prevent such adverse decisions going forward.

Lo and behold, plaintiff’s counsel in a recently filed ERISA fiduciary breach/excessive fees action have included several quotes from the Restatement in their complaint.(MFS Complaint)(1) The complaint cites both a fiduciary’s general duty to be cost-conscious, as well as specific quotes dealing with a fiduciary’s duty re cost-consciousness in selecting actively managed mutual funds. Paragraph 46 from the complaint states that

Pursuant to the prudent investor rule, fiduciaries are required to “incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.” Restatement (Third) of Trusts § 90(c)(3) (2007); see also id. § 90 cmt b (“[C]ost-conscious management is fundamental to prudence in the investment function . . . .”).

The Introductory Note to the Restatement’s chapter on trust investment further states that

[T]he duty to avoid unwarranted costs is given increased emphasis in the prudent investor rule….The duty to be cost conscious requires attention to such matters as the accumulation of fiduciary commissions with agent fees or the purchase and management charges associated with mutual funds and other pooled-investment vehicles. In addition, active management strategies involve investigation expenses and other transaction costs . . . that must be considered, realistically, in relation to the likelihood of increased return from such strategies. Where markets are efficient, fiduciaries are encouraged to use low-cost index funds. Id. § 90 cmt h(1). While a fiduciary may consider higher-cost, actively managed mutual funds as an alternative to index funds, “[a]ctive strategies . . . entail investigation and analysis expenses and tend to increase general transaction costs . . . . [T]hese added costs . . . must be justified by realistically evaluated return expectations.” Id. § 90 cmt h(2).

The investment industry is quick to try to defend a fiduciary’s selection of actively managed mutual funds on the argument that ERISA does not require that a plan fiduciary only select the cheapest investment options. While that statement is true, the referenced quotes from the Restatement also indicate that a fiduciary still has a duty to select only those actively managed funds that provide a plan and plan participants with benefits that are commensurate with the added costs and risks resulting from the actively managed funds.

This requirement poses a significant hurdle for investment fiduciaries given the historical under-performance of most actively managed funds relative to comparable index funds. As noted in my earlier posts, S&P Indices Versus Active (SPIVA) reports have consistency noted significant under-performance of actively managed mutual funds. Even worse, various studies have reported that a large percentage of actively managed funds fail to even produce returns that cover their fund’s costs.

In recent ERISA fee cases that handed down adverse rulings to plaintiffs, the courts made it a point to state that to simply allege that a fund’s expenses were higher than the fees of comparable index funds is not enough to prevent the dismissal of their case. While it could be argued that the damages suffered by plan participants as a result of higher fees is implicit in the allegations, the courts apparently want an express statement of such damages.

As I suggested in my most recent post to this blog, the Restatement provides plan participants and their counsel with the perfect blueprint of providing the courts with an applicable fiduciary standard and proof to defeat any motion to dismiss. Plaintiff’s counsel decision to reference the applicable was brilliant, as they not only quoted the applicable language, but also referenced the Supreme Court’s language from the Tibble decision stating that the courts routinely turn to the Restatement in interpreting fiduciary law under ERISA.

Given the difficulty that plan sponsors and other investment fiduciaries will have in meeting the “commensurate return” set out in the Restatement, could the format of the MFS complaint be the beginning of a trend of including the same quotes regarding the fiduciary duty of cost-consciousness in a plaintiff’s complaint in an ERISA breach of fiduciary duty/excessive fee case? Given the tendency of many cases to settle if plaintiff can survive a motion to dismiss and the strength of the Restatement’s cost-consciousness provisions, this new approach in drafting should not be summarily dismissed as unimportant.

As I pointed out in my earlier posts, the cost-consciousness approach could be even stronger if the evidence supports an argument by plan participants that a significant number of plan’s investment options were “closet index” funds. The argument would obviously be that such funds misrepresented themselves as actively managed funds, but actually were nothing more than overpriced index funds and provided no meaningful benefit to plan participants. Such an argument was used successfully by plaintiff’s counsel in the Northrup Grumman case to defeat a motion to dismiss. The case recently settled for approximately $17 million dollars.

The new approach of including a fiduciary’s duty of cost-consciousness could be a turning point in the future of ERISA fiduciary duty/excessive fee cases, especially if combined with a “closet index” fund situation. Plan participants should be able to survive most motions to dismiss by simply educating a court as the Restatement’s position and presenting evidence establishing that some or all of the investment options in the plan failed to satisfy such requirements.

This new potentially powerful combination of the Restatement’s fiduciary duty of cost-consciousness and “closet indexing” also has implications for the fiduciary duties established under the DOL’s new fiduciary rule (Rule). The cost-consciousness and “closet indexing” combo might significantly reduce the number of investments satisfying the Rule’s “best interest” requirement under both  Impartial Conduct Standards and the Best Interest Contract (BIC) exemption.

Since financial advisers will be required to document their due diligence prior to making any investment recommendations to covered plan participants and retiring employees, at the very least they will be required to address both the cost-consciousness and “closet indexing” issues or face severe penalties. As noted in my two previous posts, my metric, the Active Management Value Ratio™ 3.0 and Ross Miller’s Active Expense Ratio can help plan sponsors, financial advisers, investment fiduciaries and attorneys quantify the cost-consciousness of an investment option.

1. Velazquez v. Massachusetts Financial Services Company d/b/a MFS Investment Management, In The United States District Court for the District of Massachusetts, Case1:17-cv-11249-RWZ, Filed 07/07/17


Posted in 401k investments, BICE, closet index funds, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, IRA, IRAs, pension plans, prudence, retirement plans, RIA, RIA Compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , ,

Duty of Cost-Consciousness: The Fiduciary “Gotcha” You Think You Understand…But You Probably Don’t

While no one is certain at this point what the eventual DOL fiduciary rule will look like, or whether there will even be a DOL fiduciary rule, fiduciary law will continue to exist and establish the liability standards for investment fiduciaries. When it comes to interpreting fiduciary standards under ERISA, the courts have consistently stated that they look to Restatement (Third) Trusts (Restatement) for guidance.

Fiduciary Framework
A fiduciary’s duties of loyalty and prudence are well-known. The duty loyalty requires a fiduciary to always act in the best interests of a client, “solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries.”1 The duty of prudence requires a fiduciary to act

with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.2  

What many plan sponsors and other investment fiduciaries are not aware of is that implicit in the fiduciary duty of prudence is a duty to be cost-conscious.3 The Restatement provides guidance to fiduciaries in meeting their duty to be cost-conscious, pointing out that

Because the differences in the totality of  the costs…can be significant, it is important for the [fiduciary] to make careful overall cost comparisons, particularly among similar products of a specific type being considered for a [plan’s] portfolio.4

Many 401(k) select actively managed mutual funds as investment options within their plan. In making such a decision, the Restatement warns plan sponsors that

a decision to proceed with such a program involves judgments by [a fiduciary] that: a) gains from the course of action can reasonably be expected to compensate for its additional costs and risks,…”5

Low Hanging Litigation Fruit Under the DOL’s Fiduciary Rule and BICE

With that framework in mind, two investments that would appear to be prime targets for plaintiffs’ ERISA attorneys are variable annuities and actively managed mutual funds. Both of these products have legitimate cost efficiency issues, thereby drawing the attention of the plaintiffs’ bar.

Variable Annuities
The cost issues associated with variable annuities have been one of the main reasons that variable annuities have consistently been a leader in customer complaints to regulatory bodies. Fiduciary law is based largely on a combination of trust, agency and equity law. A basic tenet of equity law is that “equity abhors a windfall.” Common sense alone tells you that a windfall achieved at the cost of a plan participant is neither in their best interests nor for their benefit.

And yet, most variable annuities do just that, as their fee structures ensure an unfair and onerous windfall for the variable annuity issuer. In a landmark study of the fees associated with variable annuities, Moshe Milevsky estimated that the inherent value of the annual M&E fee charged by variable annuities was only between 5-10 basis points (a basis point is 1/100 of 1 percent), depending on factors such as age and gender.6 The fact that insurance companies were charging a median annual M&E fee of 115 basis led Milevsky to conclude that the M&E fee being charged was not actually related to the actual costs of providing such a benefit to variable annuity owners, and therefore,

if the M&E fee was only meant to cover true risk — the typical VA policyholder was being grossly overcharged for this so-called protection and peace of mind.7

The passage of time has not changed Milevsky’s opinion of his original findings demonstrating the windfall variable annuity issuers receive from the M&E fee, as he has recently stated that  

Indeed, I still stand behind those results. Our basic position was that for many investors, a similar financial economic outcome could be achieved at a lower cost.8

Another cost efficiency issue of a variable annuity’s M&E fee is the fact that the fee is based on an absurd process known as “inverse pricing.” Inverse pricing refers to the fact that the annual M&E fee is based on the accumulated value of the variable annuity. The M&E fee provides the death benefit for a variable annuity owner, and the death benefit guarantees that the owner will never receive less than his/her actual contributions to the variable annuity. So, variable annuity owners whose variable annuities have experienced significant appreciation, and thus do not need the death benefit, are paying a higher fee for a benefit that they cannot use.  Another windfall for the insurance company/variable annuity issuer.

The overall fees associated with variable annuities present cost efficiency issues. Variable annuities basically charge three types of fees: (1) the M&E, essentially the fee for the death benefit; (2) administrative fees; and (3) sub-account fees for the variable annuity’s investment options.  The cumulative amount for such fees is typically 3 percent or more.

Most variable annuities now offer various types of “living benefit” riders that provide minimum guarantees with regard to accumulation rates and income distributions. The fee for such additional riders is usually in the range of 1 percent for each rider selected. Given the fact that each additional 1 percent in investment fees reduces an investor’s end return by approximately 17 percent over a period of twenty years, the cost efficiency issues inherent with variable annuities is obvious.

Bottom line, in their present form, most variable annuities will never pass the fiduciary standards of loyalty and prudence. Many in the financial services industry believe that some insurance companies have decided to sell their variable annuity businesses to other companies. Unless and until variable annuity issuers create and implement strategies that are compliant with the fiduciary duty to be cost efficient, variable annuities will continue to be a prime target for ERISA’s plaintiff’s bar.

Actively Managed Mutual Funds
Anyone involved in the financial services industry is well aware of the ongoing debate concerning actively managed mutual funds and passively managed, or index, funds. The Restatement actually establishes a standard for assessing the prudence of recommending and selecting actively managed funds.

a decision to proceed with such a program involves judgments by [a fiduciary] that: a) gains from the course of action can reasonably be expected to compensate for its additional costs and risks,…”9 (emphasis added)


Category 5 years 10 Years 15 Years
All Domestic Funds 85.82 82.87 82.23
All LargeCapFunds 88.30 84.60 92.15
All MidCap Funds 89.95 96.03 95.40
All SmallCap Funds 96.57 95.64 93.21


The cost efficiency issues inherent in actively managed mutual funds is raised to another level given studies that show that the majority of actively managers fail to produce returns that even cover their fund’s costs.10

The reported inability of so many actively managed funds to even cover their costs led me to create a metric, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR builds upon the studies of investment icons Charles D. Ellis, Burton Malkiel and Mark Carhartto provide a simple cost/benefit metric that allows investors, plan sponsors and attorneys to quickly and easily evaluate the cost efficiency of an actively managed fund.

Ellis contributed the concept of evaluation based on a fund’s incremental costs and incremental return.11 Malkiel and Carhart contributed their findings that the two most reliable indicators of a fund’s future performance were its annual expense ratio and its turnover/trading costs.12

In my practice, I use the AMVR to evaluate the cost efficiency of actively managed in terms of four types of returns – nominal return, load-adjusted returns, risk-adjusted returns, and Active Expense Ratio-adjusted returns. Ross Miller’s Active Expense Ratio metric addresses the “closet indexing” issue by calculating an actively managed fund’s effective annual expense ratio based on a fund’s R-squared rating. For more information about the AMVR, click here.

My AMVR calculations support the findings that very few actively managed funds are able to produce returns that even cover their costs, much less outperform their respective benchmark. These findings should make any plan sponsor or other investment fiduciary think twice before recommending or selecting actively managed funds for their plan or clients. After all, does a prudent person invest in an investment whose past performance suggests that the investor will lose money? Does a prudent person invest in a more expensive investment when a comparable investment has a history of providing the same, or higher returns?

One common mistake I see plan sponsors make is evaluating actively managed funds using a fund’s nominal returns. In some cases, I think this error is due to the fact that fund’s typically advertise their nominal returns, even though they know the front-end sales loads their funds charge will significantly reduce the effective return their customers receive.

The financial services industry often downplays the importance of risk-adjusted returns, often by saying that “investors cannot eat risk-adjusted returns” And yet those same people and firms have no problem using Morningstar’s star ranking for their funds in their ads. Morningstar bases its star system rankings on a fund’s risk-adjusted returns.

“Closet indexing,” or index hugging, refers to a situation where an actively managed mutual fund closely tracks the performance of a relative index or index fund. Despite the fact that actively managed funds often ridicule index funds, the evidence clearly indicates that the percentage of actively managed mutual funds closely tracking comparable index funds continues to increase. Actively managed funds have apparently adopted an “if you can’t beat ’em, join ‘em” strategy in order to avoid significant variance in return that could cost them clients.

The Acceptable Range of Fee Myth
One recent development in ERISA excessive fees cases deserves special mention. Several recent court decisions have ruled in favor of 401(k) plans based on their position that the range of fees for the investment options with the plan fell with an “acceptable range” of fees based on previous court decision involving a similar range of fees.13

What is troubling with this recent trend is the fact that the financial services industry has long argues that the suitability/prudence of investments should not be based on the absolute level of the fees of an investment. And yet, that appears to be exactly what the courts are now doing, in direct opposition to the Restatement’s position.

Recent court decisions have cited the fact that ERISA does not require a plan fiduciary to select the cheapest investment option, which is true. However, ERISA also does not give plan fiduciaries carte blanche power to ignore the wants and needs of plan participants and pick more expensive actively managed funds that fail to provide plan participants with a commensurate return for the added costs and risk involved with actively managed funds.

Such an approach is clearly inconsistent with both the Restatement and the stated purpose of ERISA. As TIAA-CREF correctly pointed out,

Plan fiduciaries are required to determine whether fees are “reasonable” for the services provided and that the services support their plan goals…Plan sponsors are required to look beyond fees and determine whether the plan is receiving value for the fees paid.14

Given the overwhelming percentage of active managed funds that fail to provide any positive incremental return to investors, or whose funds fail to cover their costs, thus frustrating their expressed purpose of ERISA, courts and other regulatory bodies should base their decisions on an overall evaluation of the cost efficiency of a plan’s investment options using appropriate cost and return numbers.

The DOL’s recently announced fiduciary standard continues to face strong opposition by the financial services industry. The exact terms of the eventual fiduciary standard, or even if the new rule will survive at all, remain to be seen. That being said, 401(k) will continue to be subject to litigation based on issues such as excessive fees and the selection of imprudent investment choices.

Fortunately, plan sponsors and other investment fiduciaries can look to the Restatement to provide valuable guidance on how to create and maintain a plan that is compliant with applicable fiduciary standards, thus reducing the potential for unwanted liability exposure. Plan advisers can also use the Restatement as a compliance blueprint to provide valuable advice to their clients.

© 2017 The Watkins Law Firm. All rights reserved.

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

1. Tibble v. Edison, Int’l, 135 S. Ct 1823 (2015)
2. 29 U.S.C. §1104(1)(A)
3. 29 U.S.C. §1104(1)(B)
4. Restatement (Third) Trusts, §§ 88 cmt a, 90 cmt b
5. Restatement (Third) Trusts, §§ 90 cmt m
6. Restatement (Third) Trusts, §§ 88 cmt h(2)
7. Moshe Milevsky, “Confessions of a VA Critic,” Research Magazine, January 2007, 42-48
8. Milevsky, Ibid.
9. Restatement (Third) Trusts, §§ 88 cmt h(2)
10. Philipp Meyer-Braun, “Mutual Fund Performance Through a Five Factor Lens,” Dimensional Fund Advisors, August 2016
11. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing.”6th ed. (New York, NY: McGraw/Hill, 2018), 104.
12. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460; Mark M. Carhart, “On Persistence in Mutual Fund Performance,”The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
13. Acceptable range
14. TIAA-CREF, “Assessing the Reasonableness of 403(b) Pension Plan Fees,” available online https://www.tiaa.org/public/pdf/performance/ReasonablenessoffeesWP_Final.pdf


Posted in 401k, 401k compliance, 401k investments, 404c compliance, Annuities, closet index funds, clsoet index funds, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, IRAs, pension plans, retirement plans | Tagged , , , , , , , , , , , , , , , ,

“Apples to Apples” and Other Investment Return Issues

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

© 2017 The Watkins Law Firm. All rights reserved.

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



Posted in 401k, 401k compliance, 404c compliance, closet index funds, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, pension plans, retirement plans, RIA | Tagged , , , , , , , , , , , , , , , , , , , , ,

Quantifying the Impartial Conduct Standards Under the DOL’s New Fiduciary Rule

With a portion of the DOL’s new fiduciary rule scheduled to go into effect at midnight tonight, there are still some unanswered questions with regard to how some key terms will be interpreted. The key terms in question are primarily located in the rule’s impartial conduct standards.

The DOL has stated that the impartial conduct standards are “consumer protection standards that ensure that advisers adhere to fiduciary norms and basic standards of fair dealing.” The standards can be designated as

  • The “best interest” standard – requires that advisers always act in the best interest of a “retirement investor.” The “best interest” standard actually consists of two separate fiduciary standards: the duty of prudence and the duty of loyalty.
  • The “reasonable compensation” standard – requires that an adviser only receive “reasonable compensation in exchange for the advice and/or services provided to a customer.”
  • The “misleading statements” standard – prohibits any misleading by an adviser regarding investment transactions, compensation, and conflicts of interest.

While the “misleading statements” standard is self-explanatory, it has been suggested that it will be left to the courts and attorneys to define the meaning of “best interest” and “reasonable compensation.” As an ERISA and securities attorney, I would suggest that just as the courts look to the Restatement (Third) of Trusts to interpret fiduciary law, advisers and other investment fiduciaries can, and should, look to the Restatement for guidance as the interpretation of both terms.

“Best Interest” Standard
The fiduciary duty of prudence essentially adopts the Restatement (Third) Trusts’ Prudent Investor Rule. The Prudent Investor Rule requires a fiduciary to execute their fiduciary duties with the same care, skill and caution that a prudent investor would use in managing their own affairs.

The fiduciary duty of loyalty requires that an adviser always put the customer’s financial interests ahead of those of the adviser or the advisory firm. While the duty of loyalty does not absolutely prohibit an adviser from also benefiting from the advice or services provided to a customer, the primary reason for and resulting benefit from an adviser’s advice or actions must be to further the customer’s financial interests.

In satisfying both of these fiduciary duties, Section 88 of the Restatement states that a fiduciary has a duty to be cost conscious, i.e., limit investment selections and recommendations to investment that are cost efficient. Comments h(2) and m of Section 90 state that in choosing between similar mutual funds, actively managed funds should only be chosen if it is reasonable to assume that the fiduciary’s customer will be properly compensated for the higher fees and risks generally associated with actively managed funds. Given the poor relative historical performance of most actively managed mutual funds, the requirements set out in Section 88 and Section 90 create significant hurdles for fiduciaries in trying to meet the new fiduciary rules “best interest” standard.

“Reasonable Compensation” Standard
Most of the media commentary to date on the “reasonable compensation” requirement has centered on the absolute level of monetary compensation an adviser receives from their investment advice and related services. The suggestion has been made that the market will determine whether a certain level of monetary compensation is “reasonable.”

I would suggest that such a definition of “reasonable compensation” is too narrow, as it ignores the “reasonableness” of the adviser’s advice and services relative to the inherent value of such advice and services. Under the law of equity, the concept of quantum meruit arises when one party to a contract refuse to honor and agreement made with another party due to a disagreement over the quality of the services rendered under the agreement, the courts usually reference quantum meruit for the proposition that one is entitled to compensation relative to the inherent value of the services they provided.

I think that some attorneys may incorporate such an argument in actions filed pursuant to the new rule’s “reasonable compensation” standard, as a strong argument can be made that a determination of “reasonable compensation” properly involves both quantitative and qualitative questions. A customer dealing with an adviser obviously seeks useful and valuable advice, and has every right to expect same. Any suggestion that an adviser is entitled to compensation just for giving any advice is inconsistent with both common sense and the law.

Quantifying the Impartial Conduct Standards
One of the common complaints heard from opponents of the new fiduciary rule is that the rule does not adequately define terms such as “best interests” and “reasonable compensation,” Opponents argue that such terms are purely subjective and therefore unfairly expose financial advisers and financial institutions covered under the rule to unnecessary liability exposure.

Advocates of the rule argue that such complaints are without merit, as violations of such standards are often blatant and obvious enough that pure common sense indicate a violation of such standards. Advocates of the rule also point out that since the quality of an adviser’s advice is evaluated as of the time such advice is provided, not upon the ultimate results of such advice, there is no reason that both a qualitative and a quantitative evaluation of the adviser’s advice cannot be done to evaluate an adviser’s compliance with the rule’s “best interests” and “reasonable compensation” standards.

Various metrics currently exist that can assist advisers, customers, and plan sponsors in evaluating the quality of an adviser’s financial advice both in terms of cost efficiency and risk management. Ross Miller’s excellent Active Expense Ratio metric analyzes the cost efficiency issues inherent with “closet index” funds. The Sharpe Ratio and the Modigliani–Modigliani metric (M-squared) are two popular risk management metrics.

In my practices, I also use a proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is based on the studies of investment icons Charles D. Ellis and Burton Malkiel and analyzes the cost efficiency of an actively managed mutual fund in terms of a fund’s incremental costs and incremental returns.

The simplicity in both the calculation and interpretation of the AMVR are part of its appeal. Calculating the AMVR requires nothing more than the simple ‘My Dear Aunt Sally” (multiplication, division, addition, subtraction) skills everyone learned in elementary school. In interpreting the AMVR, the optimum score is greater than zero (indicating a positive incremental return) and less than one (indicating that the fund’s incremental returns are greater than it incremental costs).

AMVR scores less than zero or greater than one indicates that an investor in the fund would have incurred a financial loss, clearly inconsistent with the fundamental concepts of “best interest” and “reasonable compensation.”  Anyone attempting to make a good faith argument that any compensation is reasonable for recommending investment products with excessive fees and/or a historically consistent record of under-performance relative to a comparable benchmark faces a difficult challenge before an objective and impartial arbiter.

As mentioned earlier, the DOL has stated that the purpose of the new fiduciary rule is to ensure consumer protection and fair dealing with pension plans and plan participants. In interpreting the concepts of “best interest” and “reasonable compensation,” simple common sense mandates that one uses the same resources relied on by the courts in interpreting fiduciary law-applicable common law and the Restatement (Third) Trusts. Adopting this approach not only guarantees consistency in enforcement, but provides a set of guidelines that financial adviser and firms subject to the DOL’s new fiduciary can use to proactively ensure compliance with the rule’s impartial conduct standards.

© 2017 The Watkins Law Firm. All rights reserved.

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

Posted in 401k, 401k compliance, 401k investments, 404c compliance, Annuities, BICE, compliance, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, pension plans, retirement plans, RIA, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , ,

The Investor Revolution: A “Best Interests” Checklist for Investors and Fiduciaries

The DOL recently announced that it will not seek to delay the effective date of the department’s new fiduciary law. Beginning June 9, 2017, anyone providing advice to pension plans and plan participants will be deemed to be a fiduciary, which means that the adviser must always act in the plan’s/participant’s best interests.

Registered investment advisers are already held to the fiduciary standard’s “best interests” standard. Stockbrokers and other financial advisers will often argue that they are not held to the fiduciary standard’s “best interests” requirement, but rather the less stringent “suitability” standard. However the releases of FINRA, the primary body regulating stockbrokers and broker-dealers, suggest otherwise, stating that

In interpreting FINRA’s suitability rule, numerous cases explicitly state that ‘a broker’s recommendations must be consistent with his customers’ best interests. The suitability requirement that a  broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests.(1)

Regulatory enforcement decisions have further established a broker’s obligation to always act in a customer’s best interests, stating that a broker violates the suitability rule “when he puts his own self-interest ahead of the interests of his customers.”(2)

All of these “best interests” rules and regulations are nice, but how does an investor know that their financial adviser is actually complying with such rules and regulations. As a securities and ERISA attorney, I can tell you that in too many cases financial advisers are not meeting  their “best interests” obligations to their customers, both individual investors and pension plan sponsors.

Recently, I was asked by a 401(k) to forensic analysis of the investments in their defined contribution plan. An example using two of the mutual funds in their plan will hopefully point out the challenges investors and plan sponsors face in assessing the prudence of an .actively managed mutual fund.

The two actively managed mutual funds in this example are two funds commonly found in investment portfolios and pension plans, such as 401(k) plans: Fidelity Contrafund (retail (A) shares – FCNTX; Retirement (K) shares – FCNKX), and American Funds Growth Fund of America (Retail (A) shares – AGTHX, Investor (R-6) shares – RGAGX). Both of these fund are classified as large cap growth funds by Morningstar, so I will use the Vanguard Growth Index fund as my benchmark in this analysis – Retail shares VIGRX, retirement/institutional shares – VIGIX).

Retail Share Analysis

Nominal Load Adj. Risk Adj
Return Return Return
5 & 10 5 & 10 5 & 10
AGTHX 13.70 & 7.62 12.37 & 6.99 11.02 & 4.33
FCNTX 12.48 & 8.77 12.48 & 8.77 11.32 & 6.46
VIGRX 12.76 & 8.85 12.76 & 8.85 11.28 & 6.09

In short, what I did was take the funds’ nominal (reported) returns. I then adjusted for any front-end loads imposed on an investor’s investment since the load immediately reduces the amount of money, and return dollars, in an investor’s account. Finally, I adjusted for risk in the fund, using the fund’s standard deviation. The risk adjusted returns are based on a fund’s load adjusted returns. I used a fund’s five/ten-year annualized returns and five/ten-year standard deviation numbers in these calculations to reduce the possibility of any skew in the statistics.

The data clearly indicates the impact of front-end loads, as American Fund’s Growth Fund of America has the worst returns of the three funds. The Restatement (Third) Trusts clearly states that being cost efficient is one of a fiduciary’s duties. Therefore, the next step in my analysis is to use the funds’ risk adjusted returns to calculate the cost efficiency of the funds using my proprietary metric, the Active Management Value Ratio™ 2.0 (AMVR).

Incremental Incremental
Costs Return AMVR
5 & 10 5 & 10 5 & 10
AGTHX .85 NA (IR<0) NA
FCNTX  .99 .04 & .37 NA (IC>IR)
VIGRX NA (Bmrk) NA (Bmrk) NA (Bmrk)

Since AGTHX failed to outperform the benchmark, it does not qualify for an AMVR rating since it would have resulted in a financial loss for an investor relative to the less expensive benchmark. While FCNTX did produce positive incremental returns, it does not not qualify for an AMVR rating since the fund’s incremental costs exceeded such incremental returns, resulting in a net loss for an investor.

The AMVR also allows investors and fiduciaries to evaluate the cost efficiency of an actively managed mutual fund from other perspectives. For instance, using AGTHX and FCNTX, the AMVR allows us to see that 100% of AGTHX’s annual fees and costs are being wasted, as the fund did not produce any benefit for an investor, i.e., any positive incremental return, for either the five or ten year returns.

FCNTX did produce a positive incremental return for both the five and ten year period. However, given the fund’s total costs using the AMVR (117 basis points, or 1.17%), and fund’s incremental costs (99 basis points), 84% of the fund’s total annual costs were producing less than 1 percent of the fund’s five year annualized returns and only 5 percent of the fund’s ten year annualized returns. Hardly cost efficient.

These figures are hardly surprising. In fact, a study by Robert Arnott, Andrew Berkin, and Jia Ye concluded that only 4 percent of actively managed mutual funds beat the Vanguard S&P 500 Index Fund (VFINX) on an after-tax basis. Of that 4 percent, the average annual margin of outperformance was only o.6 percent, while those funds that failed to outperform VFINX did so by a “wealth destroying” 4.8 percent annually.(3)

The final step in my forensic analysis is to address the potential “closet  index” issue for both AGTHX and FCNTX. “Closet index,” also known as “index hugger,” funds are actively managed mutual funds that closely track a market index or an index fund that track an index, yet charge investors significantly higher fees than comparable index funds.

To evaluate a fund’s “closet index” factor, I re-calculate the funds’ AMVR scores using Ross Miller’s Active Expense Ratio (AER) metric. The AER uses a fund’s R-squared number to calculate the effective expense ratio for an actively managed fund. AGTHX’s 5/10 AER scores were 1.83 and 2.83, respectively, FCNTX’s 5/10 AER scores were 1.51 and 2.70, respectively. Since the AER scores greatly exceed the incremental returns produced by both funds, they would be cost inefficient and do not qualify for an AMVR score.

Retirement Share Analysis

Nominal Risk Adj.
Return Return
5 & 10 5 & 10
RGAGX 14.08 & 7.91 12.81 & 5.24
FCNKX 12.60 & 8.88 11.44 & 6.57
VIGIX 12.93 & 9.03 11.56 & 6.26

Notice that there is no column for load adjusted returns for the retirement shares. Due to the provisions of the Employees’ Retirement Income Security Act (ERISA), retirement shares classes should not impose a front-end load on investors. Investors share classes are allowed to imposes so-called 12b-1 fees on investors. Such fees are required to be disclosed in a fund’s prospectus. Investors should note if a fund imposes 12b-1 fees and generally reject such funds since any fee reduces an investors end-returns.

Again, the next step is to calculate the funds’ AMVR score based on their risk adjusted return.

Incremental Incremental
Costs Return AMVR
5 & 10 5 & 10 5 & 10
RGAGX .52 1.25 & NA .32 & NA
FCNKX .97 NA & .31 NA/(IC>IR)

Using RGAGX and FCNKX, the AMVR shows that 100% of RGAGX”s annual fees and costs are being wasted with regard to the fund’s ten-year annual return, as the fund did not produce any benefit for an investor, i.e., any positive incremental return, during that period. The five-year annualized return resulted in a very respectable AMVR score of .42 due to the combination of the fund’s high incremental return and low incremental costs. However, from another cost efficiency perspective, 34 percent of the fund’s annual fees and costs were only producing approximately 9.75 percent of the fund’s five-year annualized return.

FCNKX did not produce a positive incremental return for the fund’s five-year return, so the fees and costs for that period were totally wasted. FCNKX did produce a positive incremental ten-year return However, the fund did not qualify for an AMVR score since its incremental costs were approximately three times the fund’s incremental return. given the fund’s total costs and fund’s incremental costs, 84% of the fund’s total annual costs were producing approximately 4.7 percent of the fund’s ten-year annualized return. Hardly cost efficient.

Again, I re-calculate the funds’ AMVR scores use Ross Miller’s Active Expense Ratio (AER) metric. RGAGX’s 5/10 AER scores were 1.93 and 2.41, respectively, FCNKX’s 5/10 AER scores were 2.96 and 3.46, respectively. Since the AER scores greatly exceed the incremental returns produced by both funds, they would be cost inefficient and do not qualify for an AMVR score.

Investors and investment fiduciaries, such as 401(k) and other pension plan sponsors are often misled by mutual fund ads, which usually reports their funds’ returns based on the funds’ nominal returns. Such data may not provide a meaningful picture since nominal returns fail to factor in the impact of such issues as front-end loads, cost efficiency and potential “closet index” issues. As shown herein, such issues can reveal the true character of an actively managed fund, exposing the fund as an imprudent investment choice for an investor or pension plan.

Stockbrokers and investment advisers are legally required to perform a due diligence analysis on an investment prior to recommending the investment to anyone in order to ensure that the investment is appropriate and in best interest of their clients. Sadly, my experience as a litigator has shown that if a due diligence analysis is done at all, it is usually cursory at best, if done at all. When I produce my analysis, the usual response is the proverbial “deer in the headlights” look.

I’m not saying my approach is the only acceptable method of analysis. However, my analysis does address legally accepted and legitimate issues with regard to the quality of investment advice. Therefore, I routinely suggest to investors, pension plan sponsors and other investment fiduciaries that they ask their financial advisers if they have considered such issues in making their recommendations and if so, would they provide then with a copy of their findings. If the financial adviser indicates that they have not considered such factors, are not legally required to do so, and unwilling to do so for you, I would keep looking for a financial adviser more dedicated to better protecting your financial security and protecting you against unwanted personal liability,

1. FINRA Regulatory Notice 12-25.
2. Scott Epstein, Exchange Act Release 59328, 2009 LEXIS 217, at *42.
3. Robert Arnott, Andrew Berkin, and Jia Ye, 2000, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Journal of Portfolio Management, vol. 26, no. 4 (Summer):84–93.

© 2017 The Watkins Law Firm. All rights reserved.

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





Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, retirement plans, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , ,

The Courts, the Restatement of Trusts, ERISA and Fiduciary Liability

Yesterday, I posted an article written by a fellow attorney, Ary Rosenbaum. The article, “Simple Advice to Retirement Plan Sponsors,” provided sound advice on a number of key topics for pension plan fiduciaries.

As an ERISA and fiduciary attorney, it has always amazed me how many people that serve in a fiduciary capacity, whether in an ERISA or non-ERISA capacity, have never taken the time to actually read the Act and the related regulations, the Restatement (Third) Trusts (“Restatement”), or the key fiduciary legal decisions regarding same.  These materials are key in determining the applicable standards for legal liability for fiduciaries.

Given the fact that fiduciaries may face unlimited personal liability for violations of their fiduciary duties, one would think that they would want to know the applicable rules so that they can avoid unnecessary and unwanted such potentially life-changing liability. Yet, my experience is that very few non-professional fiduciaries understand the applicable fiduciary standards and very few have made any effort to educate themselves on such standards.

As the Supreme Court pointed out in the recent Tibble decision1, the courts often look to the Restatement in determining applicable fiduciary law in ERISA cases, since ERISA is essentially a codification of the Restatement. The same is true for courts in non-ERISA fiduciary cases, as courts in non-ERISA fiduciary actions look to both the Restatement and the Restatement Agency.

In my consulting and litigation practices, I have several “go-to” provisions of the Restatement that describe key duties of a fiduciary. While these key provisions are not, and are not intended to be, a substitute for a complete reading of the previously mentioned materials, they are worth reviewing and remembering.

ERISA Fiduciaries
One of the arguments that I often hear from ERISA fiduciaries is that they are not legally required to choose the least expensive investment option available. While this is absolutely true, to suggest that cost is not a factor that must be seriously considered in selecting a plan’s investment options would be a dangerous misinterpretation of ERISA and it stated purpose.

Section 88 of the Restatement states that one of a fiduciary’ key duties is to be cost conscious.2 Section 90 of the Restatement references Section 7 of the Uniform Prudent Investor Act, which warns that “wasting beneficiaries money is imprudent,” and cites a fiduciary’s duty to minimize costs.

Most pension plans use mutual funds as the primary investment options within their plan. The Restatement states that fiduciaries should carefully compare the cost associated with a fund, especially when considering funds with similar objectives and performance.3 The Restatement advises plan fiduciaries that in deciding between funds that are similar except for their costs, the fiduciary should only choose the fund with the higher costs if

the course of action in question can reasonably be expected to compensate for its additional costs and risk,…4

Given the historical under-performance of many actively managed mutual funds, this can be a significant hurdle that pension plan fiduciaries too often fail to properly consider. A higher priced fund that fails to provide a tangible benefit to a plan participant, namely a higher positive incremental return, has no inherent value to a n investors and is therefore clearly imprudent.

Therefore, to simply say that a fiduciary is not legally bound to select the least expensive investment option can be misleading, as other factors must be considered. TIAA-CREF properly summed up a plan sponsor’s fiduciary obligations with regard to factoring in an investment’s costs, stating that

[p]lan sponsors are required to look beyond fees and determine whether the plan is receiving value for the fees paid. This should include an evaluation of vital plan outcomes, such as retirement readiness, based on their organization’s values and priorities.5

One of the most annoying trends that I see in many ERISA-related court decisions is the concept of an acceptable range of fees for a plan’s investment options. As the TIAA-CREF quote correctly point out, given the stated purpose of ERISA, assessing the prudence of investments within a pension plan based purely on the costs associated with such investment options is itself imprudent.

Apparently some courts have lost sight of ERISA’s stated goal, that being to protect workers and to help them prepare for retirement. A prudent pension plan investment option is one that is cost efficient, one whose benefits are at least commensurate with the extra cost involved. Consequently, a fund with higher costs, but commensurable returns, would be more prudent than a less expensive fund with a consistent history of relative underperformance. The problem for many plan sponsors and other plan fiduciaries is the history of consistent underperformance by many actively managed mutual funds relative to passively managed index funds.

Another challenge for plan sponsors with regard to their fiduciary duty to be cost conscious has to do with so-called “closet index” mutual funds. A closet index fund, or “index hugger,” is an actively managed mutual fund that closely tracks a relevant index or index fund, yet charges significantly higher fees than an index fund. Fiduciaries  who chose to offer or to invest in closet index funds face the challenge of justifying the selection of such funds since they could receive the same or, in some cases, better returns from comparable, less expensive index funds. Remember, wasting beneficiaries’ money is always imprudent.

When plan sponsors and their plans are challenged on the prudence of their investment choices, they often try to justify their choices based on allegations of good faith/ignorance and/or the use of modern portfolio theory (MPT) in selecting the plan’s investment options. Plan sponsors and other plan fiduciaries quickly learn that the courts have consistently rejected such defenses. A well-known quote in ERISA breach of fiduciary duty cases is that “a pure heart and an empty head are no defense.”6 The courts have also stated that MPT alone is not a complete defense in fiduciary breach of duty cases involving a defined contribution plan, as prudence is determined as to each investment option in a plan, not with regard to the plan’s investment options as a whole7

Non-ERISA Fiduciaries
Most of what has already been discussed in the context of ERISA fiduciaries is equally applicable to non-ERISA fiduciaries. With non-ERISA fiduciaries, the threshold question is whether or not the stockbroker or financial adviser is even a fiduciary for liability purposes.

Most stockbrokers and financial advisers are not deemed to be fiduciaries for their customers unless they contractually agree to assume such responsibilities, such as managing an account on a discretionary basis, or they are deemed to have taken control of a customer’s account. The “taken control” requirement is generally met when it can be shown that a customer routinely acted in accordance with whatever their  stockbroker or financial adviser recommended. Investment advisers are held to a fiduciary standard by law, which requires them to always act in a client’s best interests.

One development that stockbrokers and financial advisers are often unaware of is that the courts have shown an increasing willingness to impose a fiduciary standard on such investment professionals, even in connection with non-discretionary accounts, when they feel such is necessary to protect naïve or inexperienced investors. The courts have stated that the applicable standard in deciding whether to impose a fiduciary standard on such investment professionals is

whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.8

[w]hether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions and to reject one when he thinks it unsuitable.9

With the pending implementation of the DOL’s new fiduciary rule, stockbrokers and other financial advisers should take notice of these decisions and recognize situations that potentially create  a greater risk of being held to the fiduciary standard’s higher “best interests” standard, as opposed to their normal, less stringent suitability standard. Retirees, older customers, women and those suffering some sort of mental impairment are often mentioned as customers who courts would consider as meriting special fiduciary protection.

The courts are becoming more protective of employees and others involved in investing activities. The recent court decisions rejecting challenges to the Department of Labor’s new fiduciary rule are a perfect example of this fact. Given that fiduciaries may face unlimited personal liability for any breach of their fiduciary duties, the prudent fiduciary, in both ERISA and non-ERISA situations, will take the time to educate themselves on both existing and future applicable fiduciary standards and develop due diligence programs than ensure compliance with same.

1. Tibble v. Edison International, 135 S.Ct. 1823, 1828 (2015).
2. Restatement (Third) Trusts §88.
3. Restatement (Third ) Trusts §90 cmt m.
4. Restatement (Third) Trusts §90 cmt h(2).
5. TIAA-CREF, “Assessing the Reasonableness of 403(b) Fees,” available online at  https://www.tiaa.org/public/pdf/performance/ReasonablenessoffeesWP_Final.pdf.
6. Donovan v. Cunningham, 716 F.2d 1455, 1468 (5th 1983).
7. DiFelice v. U.S. Airways, 497 F.3d 410, 423-24 fn. 8 (4th 2007).
8. Carras v. Burns, 516 F.2d 251, 258-59 (4th 1975).
9. Follansbee v. Davis, Skaggs & Co,, Inc., 681 F.2d 673, 677 (9th Cir. 1982).

© 2017 The Watkins Law Firm. All rights reserved.

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

Posted in fiduciary compliance

Guest Column-Simple Advice to Retirement Plan Sponsors

I generally do not post or allow other parties to post on any of my blogs due to legal concerns. However, Ary Rosenbaum is a fellow attorney and posts some extremely useful and informative material online with regard to ERISA matters for 401(k) plans and plan sponsors. In an effort to provide my followers with the best information and advice to help them build and protect their practices, Ary has graciously agreed to let me post some of his past and present posts on my blogs. I would strongly recommend following Ary online as well to ensure that you receive his posts and articles. His social media and professional information is provided at the end of this article. Enjoy!

Simple Advice to Retirement Plan Sponsors
By Ary Rosenbaum, Esq.

I don’t know about you, most of the advice I got growing up was usually wrong. Maybe some very unsuccessful people surrounded me when I was younger, but advice can be biased and self-serving at times. The best advice I would ever get was from successful people with great people skills and confidence in their own abilities. The problem with advice given to plan sponsors is that it’s often self-serving by the plan providers who want to maintain or get the business from plan sponsors. So this article is simple advice to retirement plan sponsors that you can take or leave, I won’t be offended. Of course if they don’t take it, it may cost them.

Remember why you put the retirement plan in the first place. 
They say the road to hell is paved with good intentions and whoever coined that phrase must have been a retirement plan sponsor because fiduciary responsibility and potential liability can be a headache. As a plan sponsor, you should always remember why you put it in the first place, to save for retirement for yourself and for your employees. If you never lose sight of that, then it makes it easier to understand your responsibility as a plan sponsor/fiduciary. When you remember that your money is there and you employee’s money there, you become more vigilant. If you forget that and treat the retirement plan like that dirty K-cup machine in the break room, your plan is going to be as disheveled as that coffee machine.

Less is more when it comes to 401(k) fund lineups
We are a country of excess, just look at the national average weight. We usually think that more is more, so food portions at the local national chain restaurant can feed a Bulgarian weightlifter. The problem is that many times, more is not more, less is more. Eye makeup, men’s cologne, and Old Milwaukee beer are examples of when less is more. The same can be said with 401(k) fund lineups where participants direct their own investments. Studies have shown that the more investment options available under the Plan, it has the unintended effect of depressing plan participation in salary deferrals. While it may seem like a good idea to offer 30+ mutual funds in the plan because we think more choice is good, it actually overwhelms plan participants so much that they decide not to defer and actively participate in the Plan. Information overload isn’t something any plan sponsor wants to provide plan participants, but it’s an unintended consequence of giving too many choices. There is no reason that any plan should include more than 12-15 mutual funds (not including target date funds) because that should be enough to be a good cross of diversified investment options.

Blind loyalty to plan providers is bad
I have worked at places where the employer had loyalty to employees and it usually was misplaced. Too often, employers think that employees are loyal and that loyalty deserves reciprocity just because they have been there so long. Longevity should not be confused with loyalty because some employees are too incompetent to go somewhere else. Being loyal to someone or to a provider should be more than longevity. When it comes to plan providers, loyalty can be a reward for competent plan providers and it’s a disaster if you have an incompetent plan provider. There are many reasons to have long-term providers because of cost, familiarity, and competence. Keeping a plan provider just because they have been there for that long reminds me of the actuary who wasn’t good at his job and who we could never bring out for a sales meeting. Too often, I had to fix major errors with retirement plan clients because of the incompetent work of plan providers. After fixing these errors, the plan sponsors state that they can’t believe because they were using that provider for so long. There is nothing wrong with being loyal to plan providers, but you still need to benchmark fees and review their work. Blind loyalty will make you blind to the problems that might be affecting your Plan.

Plan design is more important than you think
If you had two accountants and they both prepared tax returns to the letter of the law and one could get you a $1,000 refund and another could get you a $5,000 refund, who would you pick? Retirement plan design is a pretty hard concept for even retirement plan professionals to understand, so laypeople like plan sponsors don’t understand it and don’t value it. Like the accountant who could produce a better tax return, a good retirement plan design could help a plan sponsor like you maximize retirement savings for the highly compensated employees which means larger tax deductions. The best example is the work I did for a 75-year-old attorney many years ago. He had a self-employed pension plan where the maximum contribution at the time was $49,000. I was able to have an actuary design a defined benefit plan where he could put away $230,000 instead. That’s a lot of shekels. Thanks to concepts such as cash balance plans, safe harbor 401(k), and new comparability/cross tested plans, you could save a lot more for retirement than just using a plain vanilla plan design where everyone gets the same pro-rata contribution. So when it comes to selecting a TPA, one should always consider whether the TPA is proficient in plan design because there are many that are not. Picking a TPA that doesn’t have plan design expertise may require more mandatory contributions to the rank and file employees or not enough contributions to the highly paid.

There isn’t anything out there that is a fit for every retirement plan sponsor
Retirement plan service providers are very creative in crafting retirement plan solutions for their current and potential plan sponsor clients. These solutions may be a sophisticated plan design such as safe harbor or a white glove fiduciary solution like an ERISA §3(38) or ERISA §3(16) service. While these can be great solutions for many or most retirement plans, it’s not a solution for everybody. For example, an ERISA §3(38) fiduciary is a great solution where a financial advisor will exercise discretionary control over the fiduciary process and assuming the liability that goes with it. While delegating control of the fiduciary process maybe a great idea, retirement plan sponsors that have proven that can effectively manage the fiduciary process don’t need to give it up. A safe harbor 401(k) plan design is a great tool when combined with a cash balance plan and/or new comparability plan, but if a plan sponsor can’t afford employer contributions and/or if the plan’s compliance testing isn’t an issue; it’s not necessary. Retirement plan features are not one size fits all, it needs to fit the actual needs of your plan.

Being a plan sponsor is a never-ending marathon
When retirement plan sponsors start their plan, they act like they are running a 100-yard dash. They are so quick to get everything in place and hire the plan provider, but then stop when everything is done just like the finish line at 100 yards. However, being a plan sponsor is a never-ending marathon. The race to keep the plan running and avoiding liability is a never ending marathon because a plan requires constant monitoring and upkeep. You should treat running a plan like a marathon, so that means proper pacing and regular intervals of plan review. So you need to review fees, plan design, and plan provider services on a regular annual basis. Reviewing isn’t enough, you also need to memorialize these reviews to cover your “rear-end” in any potential litigation.

Picking providers just on cost is a big mistake
Plan sponsors have a fiduciary duty to pay only reasonable plan expenses. That doesn’t mean that a plan sponsor has to pay the lowest plan expenses, it just has to be reasonable based on the services provided. A plan sponsor can determine reasonableness by shopping the plan around or by benchmarking fees. One of the biggest fears concerning the fee disclosure regulations that were implemented in 2012 was that there would be a race to zero and plan sponsors would gravitate towards plan providers that charged the lowest fees. Picking a plan provider just based on their low fee is an absolute mistake. While there are many low cost plan providers that do a good job, there are those no frill providers that aren’t good at what they do and will end up being more expensive when the plan sponsor has to pay to fix compliance mistakes caused by incompetent low cost providers. There are many reasons to pick a plan provider, just because they charge the lowest fee shouldn’t be the only reason in selecting a plan provider

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