The Often Overlooked Fiduciary “Gotcha”: The Fiduciary Duty (and Challenge) of Cost-Consciousness

The vast majority of active managers are unable to produce excess returns that cover their costs.1

I recently posted an article discussing a brilliant complaint that was filed in connection with a new 401(k) excessive fees/breach of fiduciary duties action. The beauty of the complaint was that it was the first time that I have seen any attorneys address the alleged breaches in terms of the fiduciary duty of cost-consciousness, as set out in the Restatement.

Comment b of Section 90 of the Restatement (Third) Trusts states that a fiduciary has a duty to be cost-conscious in carrying out their duties.2 I have long wondered why more plaintiffs’ attorneys, plan sponsors and other investment fiduciaries have not fully utilized the cost-consciousness “blueprint” that the Restatement provides in drafting pleading and addressing potential liability exposure based on alleged breaches of a fiduciary’s duties of loyalty and/or prudence. The blueprint is a four-step process:

  1. The fiduciary duties of loyalty and prudence, as set out in both ERISA3 and the Restatement.4
  2. The duty of cost-consciousness as a sub-set of the duty of prudence.5
  3. The fiduciary duty to efficiently managing the cost/return/risk relationship of investments.6
  4. The fiduciary duty of cost-consciousness relative to the selection of actively managed mutual funds.”7

The investment industry and even some courts have been quick to reference that fact that ERISA does not require an ERISA fiduciary to always select the least expensive investment option, which is true. However, neither ERISA nor the Restatement gives an ERISA fiduciary carte blanch power to just select any investment option without consideration of the corresponding benefit derived from any additional costs and/or risks associated with the more expensive investment option. The absurdity of such an argument is obvious, as it would essentially nullify the basic fiduciary duties of loyalty and prudence.

The stated mission of ERISA and the Restatement is to protect the rights and interests of American workers and the public. In addressing the selection of investment options for a pension plan, the Restatement sets out two vital considerations,

[Fiduciaries], like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and costs for a particular level of expected return-or, inversely, the highest return for a given level of risk and cost.8  

A decision to [select actively managed mutual funds] involves judgments by the [fiduciary] that a) gains from the course of action in question can be reasonable expected to compensate for its additional costs and risks;…9

And there it is, the potential cost-consciousness “gotcha.”  As the opening quote states, not only do a large percentage of actively managed mutual funds fail to outperform a their appropriate benchmarks, they fail to even covert their own costs! Studies such as the Standard & Poor’s SPIVA reports10 and academic studies11 consistently show that the overwhelming majority of actively managed mutual funds underperform comparable index funds, thus failing to compensate for their often significantly higher fees and expense. As the introduction to Section Seven of the Uniform Prudent Investor states, “wasting beneficiaries’ money is imprudent.” The combination of an imprudent recommendation/ selection of investment options and engaging in conduct that is not in the best interest of clients/ beneficiaries clearly indicates a breach of one’s fiduciary duties.

Bottom line – There is no carte blanch power in plan advisors, plan sponsors or other plan fiduciaries in recommending and/or selecting investment options. Incurring additional costs or risks without a commensurate benefit for such additional costs or risks is a violation of the fiduciary duties of loyalty and prudence.

The Active Management Value Ratio™ 3.0
The fact that the referenced complaint chose to expressly incorporate the fiduciary duty of cost-consciousness, combined with the above-referenced requirements, creates a difficult hurdle for any defense to overcome for one simple reason-most of the investments products currently on the market do not satisfy these requirements.

I have written extensively on a metric that I created, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is based on the studies of investment icons Charles D. Ellis and Burton G. Malkiel. Ellis advocates that the proper way to evaluate investment costs is in terms of an investment’s incremental costs relative to its incremental return.12 Malkiel studies have concluded that the two best predictor’s of as mutual fund’s performance are its annual expense ratio and its portfolio turnover.13

The AMVR evaluates the cost-efficiency of an actively managed mutual fund in terms of its incremental, or additional, costs relative to its incremental return, if any, over and above a comparable benchmark, usually a comparable index fund. My experience has been that very few funds are able to produce positive incremental returns. Even when an actively managed fund does produce positive incremental returns, they often fail to produce returns that exceed the incremental costs incurred in producing such positive returns. Articles regarding the AMVR can be found here and here. In addition, each year I do a forensic analysis of the top ten non-index funds used within defined contribution plans, as reported by “Pensions and Investments.” Samples of past analyses are available here.

The “Closet Index Fund” Factor
Another issue that makes it difficult for plan sponsors to meet the “commensurate benefit” requirement of the fiduciary duty of cost-consciousness is the increasing use of “closet indexing” by mutual funds. Closet indexing refers to situations where a mutual fund holds itself out as an actively managed mutual fund, and charging higher fees for such active management, but whose actual performance closely tracks that of a comparable, but less expensive, index fund.

Two well-known methods for assessing “closet indexing are Russ Miller’s Active Expense Ratio (AER) metric, and Martijn Cremer and Antti Patejisto’s Active Share metric. For my forensic analyses I prefer to use AER because I find it easier to calculate and interpret. The AER is based on a fund’s R-squared rating, which is widely available online

There is no universally mandated level of R-squared for designating a fund as a closet index fund. However, a fund’s R-squared rating does help to provide a meaningful analysis of the effective expense costs that an investor is paying due to the misrepresentation of the extent of active management that a fund is providing. Miller’s research found that funds with high R-squared ratings, and thus low contributions from active management, often had effective expense rates 300-400 percent higher than their stated expense ratios.

My experience has been that very few plan sponsors and other investment fiduciaries even factor in a fund’s R-squared rating in their required due diligence process. This could result in increased personal liability exposure since the courts and regulators assess compliance with one’s fiduciary duties based upon what a fiduciary knew or should have known as a result of a properly conducted due diligence analysis.14

I recently ran a forensic analysis on the mutual fund universe of retirement shares of domestic equity-based mutual funds. The purposes of the analysis was to study the impact of various levels of a fund’s R-squared rating on fiduciary cost-consciousness/ fiduciary prudence standards. The results of my analysis on the large cap retirement funds sectors is attached as Appendix A.

In my analysis, I used the five-year trailing returns of Admiral shares of three Vanguard funds as my benchmarks: Vanguard S&P 500 Index Fund, Vanguard Growth Index Fund, and Vanguard Value Index Fund. I used data provided on the Morningstar Investment Research Center program. In my “closet index” analysis, I screened for retirement class funds that outperformed the relative benchmark fund with R-squared rating of 95 or below, 95 and above, 90 or below and 90 and above.

The analysis produced good news and potentially bad news for plan advisors, plan sponsors and other plan fiduciaries.  The good news – there were a number of funds that did outperform their relative benchmark’s return performance in all three large cap categories. The bad news – once cost-consciousness factors such as a fund’s annual expense ratio and turnover ratio were factored in, only the benchmark fund, and in some cases other share classes of the benchmark fund, survived the cost-efficiency screen.

Additional analyses could be done increasing the turnover and/or expense ratio numbers. However, anyone making such changes needs to consider two key issues. First, each additional 1 percent in additional fees reduces an investor’s end return by approximately 17 percent over a twenty year period. Second, increasing a fund’s incremental costs with a corresponding increase in the fund’s incremental return increases the odds of a fund failing the AMVR’s fiduciary cost-efficiency screens. Once again, “wasting beneficiaries’ money is imprudent.”

Conclusion
While most people are aware of the fiduciary duty of prudence, my experience has been that most are not aware of the Restatement’s position on the duty of cost-consciousness as a sub-set of the duty of prudence. I believe that the recently filed complaint in the MFS ERISA 401(k) action has alerted some people to the cost-consciousness requirement for fiduciaries.

With increasing awareness of a fiduciary’s duty of cost-consciousness, and the difficulty in complying with such duty give the qualities of many of the investment products currently in the market, I believe that plan sponsors and other plan fiduciaries face a daunting challenge to make their plans ERISA compliant and to reduce their risk of personal liability for a failure to do so.  The selection of truly objective, informed and experienced ERISA experts to help them face such challenges will therefore become more valuable than ever before.

Notes
1. Philipp Meyer-Browns, “Mutual Fund Performance Through a Five Factor Lens,” DFA White Paper (August 2010)
2. Restatement (Third) Trusts, Section 90 cmt. b; Tibble v. Edison Int’l, 843 F.3d 1187, 1197
3. 29 C.F.R. Section 2550.401a-1 et seq.
4. Restatement (Third) Trusts, Sections 77, 78 and 90
5. Restatement (Third) Trusts, cmt b
6. Restatement (Third) Trusts, cmt f
7. Restatement (Third) Trusts, cmt h(2)
8. Restatement (Third) Trusts, cmt f
9. Restatement (Third) Trusts, cmt h(2)
10. http://us.spindices.com/spiva/
11. Mark M. Carhart, “On Persistence in Mutual Fund Performance, ”The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
12. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing.”6th ed. (New York, NY: McGraw/Hill, 2018), 104.
13. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
14. 29 C.F.R. Section 2550.404a-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.

APPENDIX A

Morningstar Cost-Consciousness  R-squared Analysis
Large Cap Blend
Funds Screen Funds Screen
173 Return >= VFIAX 173 Return >= VFIAX
97 R-squared <= 95 76 R-squared >= 95
1 Turnover <=  4% 1 Turnover <= 4%
0 Exp. Ratio <= .04% 1* Exp. Ratio <= .04%
Funds Screen Funds Screen
173 Return >= VFIAX 173 Return >= VFIAX
57 R-squared <= 90 116 R-squared >= 90
0 Turnover <=  4% 2 Turnover <= 4%
0 Exp. Ratio <= .04% 1* Exp. Ratio <= .04%
* Vanguard S&P 500 Index Fund – Admiral Shares
Large Cap Growth Funds
Funds Screen Funds Screen
380 Return >= VIGAX 380 Return >= VIGAX
380 R-squared <= 95 0 R-squared >= 95
19 Turnover <=  11% 0 Turnover <= 11%
2* Exp. Ratio <= .06% 0 Exp. Ratio <= .06%
Funds Screen Funds Screen
380 Return >= VIGAX 380 Return >= VIGAX
308 R-squared <= 90 72 R-squared >= 90
15 Turnover <=  11% 4 Turnover <= 11%
0 Exp. Ratio <= .06% 2* Exp. Ratio <= .06%
*Vanguard Growth Index Fund – Admiral and Institutional shares
Large Cap Value Funds
Funds Screen Funds Screen
89 Return >= VIGAX 89 Return >= VIGAX
85 R-squared <= 95 4 R-squared >= 95
2 Turnover <=  4% 0 Turnover <= 4%
2* Exp. Ratio <= .04% 0 Exp. Ratio <= .04%
Funds Screen Funds Screen
89 Return >= VIGAX 89 Return >= VIGAX
69 R-squared <= 90 20 R-squared >= 90
0 Turnover <=  4% 2 Turnover <= 4%
0 Exp. Ratio <= .04% 2* Exp. Ratio <= .04%

* Vanguard Value Index Fund – Admiral and Institutional shares

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“Upon Further Review: Do We Already Have a Universal Fiduciary Standard?” Redux

Back in 2013 I posted an article dealing with the controversy over the DOL’s proposed fiduciary standard. In that article, I suggested that a universal fiduciary standard was already in place that applied to stockbrokers, investment advisers and anyone else providing investment advice to the public. A significant portion of the DOL’s rule has now become effective, with the remainder scheduled to become effect the first part of 2018.

And yet the efforts to repeal the DOL’s fiduciary standard continue. Members of the Trump administration, Congress, new DOL Secretary Acosta and new SEC Chairman Cutler have all expressed opposition to the rule. So again, I sit back and shake my head and re-ask my original question – Is this whole debate over a universal fiduciary standard actually a moot point?

While I am a staunch advocate for a clear, unmistakable universal fiduciary standard so that there is no question about the duties every financial adviser owes a customer, I would suggest that anyone who provides financial and investment advice to the public is subject to the fiduciary standard’s “best interest” requirement.

There are basically four ways that an adviser acquires fiduciary status: by contract or express agreement; by state common laws and/or regulatory rules; by control over a discretionary account; and by having de facto control over a non-discretionary account. Fiduciary status based upon contract is fairly obvious. However, financial advisors may not be as familiar with the other three methods of acquiring fiduciary status.

Registered investment advisers and their representatives are fiduciaries pursuant to the Investment Advisers Act of 1940 (’40 Act). IA-1092 clearly establishes that those holding themselves out as financial planners and/or offering to provide financial planning services to the public are fiduciaries. Stockbrokers who manage customer accounts on a discretionary basis are fiduciaries. The argument has always centered on the applicable standard for stockbrokers involved with non-discretionary customer accounts.

Broker-dealers and stockbrokers are quick to point out that they are not covered under the ‘40 Act and therefore are generally not subject to the fiduciary standard’s “best interest” A closer look at rules, regulations and court decisions suggest that broker-dealers and stockbrokers may be operating under a false sense of security.

An argument definitely can be made that under FINRA’s suitability rule, Rule 2111, all stockbrokers must adhere to the fiduciary standards and always put their customers’ best interests first ahead of their own financial interests. Rule 2111 was introduced in FINRA Regulatory Notice 11-02, with subsequent notices of guidance in FINRA Regulatory Notice 11-25 and FINRA Regulatory Notice 12-25.

While Rule 2111 was designated as a rule on suitability, many readers took particular notice of footnote 11. Footnote 11 is significant in that it referenced previous enforcement and disciplinary proceedings which addressed a stockbroker’s duties in terms of a customer’s “best interests,” more specifically that “a broker’s recommendations must be consistent with the customer’s best interests” and “a broker’s recommendations must serve his client’s best interests.”(1)

The references to a customer’s “best interests” raised immediate questions among many given its similarity to the fiduciary duty of loyalty set out in both the Restatement of Trusts and the Employees’ Retirement Income Security Act (ERISA). The current debate over a universal fiduciary standard is due in large part over the fact that the “suitability” so often referred to as the applicable standard for stockbroker does not require that recommendations provided to customers necessarily be in their “best interests.”

To its credit, FINRA did not backtrack from its position that broker’s recommendations have to be in a customer’s best interests. FINRA responded by noting that the position had been clearly stated in numerous cases and that the “best interests” requirement “prohibits a broker from placing his or her interests ahead of the broker’s interests.”(2)

You make your own decision, but the prohibition against the broker putting his or her interests before those of a customer sound very familiar to language requiring that a ERISA fiduciary always put a client’s interests first, with “an eye single to the interests of the participants and the beneficiaries,”(3) with ERISA’s requirement that a fiduciary act “solely and exclusively” for the benefit of the plan’s participants and beneficiaries(4) , and the Restatement of Trusts’ requirement, in compliance with the fiduciary duty of loyalty, that a fiduciary act solely in the interests of the beneficiaries.(5)

The courts look at various factors in determining whether an adviser had de facto control over an account justifying the imposition of the fiduciary standard on an adviser. As the courts have stated,

[t]he touchstone is whether or not the customer has the intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.(6)

the issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions.(7)

If the answer to these questions is in the negative, then the likelihood is that the adviser will be deemed to have had de facto over the customer’s account and they will be held to a fiduciary standard in their dealings with the customer and the account.

So the common argument against a universal fiduciary standard, namely that it would result in higher costs for customer’s, makes no sense since requiring all stockbrokers to put a customer’s interests first is arguably already the applicable standard. Enacting a universal fiduciary standard would simply be a codification of the applicable standard for both registered investment advisers, brokers and anyone else purporting to provide investment advice to the public.

From the public’s perspective, a universal fiduciary standard would eliminate the confusion which obviously exists regarding what duties are owed by one’s financial/investment adviser and better protect the public in their dealings with investment professionals, both of which are consistent with the mission statements of both the Department of Labor and the Securities and Exchange Commission.

So, in response to my original question, there is nothing onerous or unfair about requiring that anyone that provides financial or investment advice to the public must always put the public’s interest ahead of their own financial interests? In fact, that is actually the current standard for both registered investment advisers and stockbrokers.

So if either the Department of Labor and/or the Securities and Exchange Commission refuse to adopt a universal fiduciary standard in order to better protect the public, the public has a right to know the true reason for not doing so. Americans are getting tired of the continuous cover-ups and misinformation, the partisan politics that deny the public the protection they need.

As the court recognized in Archer v. Securities and Exchange Commission,

[t]he business of trading in securities is one in which opportunities for dishonesty are of constant recurrence and ever-present. It engages acute, active minds trained to quick apprehension, decision and action. The Congress has seen fit to regulate this business.(8)

The mission statements of both the Department of Labor and the Securities and Exchange Commission recognize a similar duty to protect the public with regard to investment related activities that impact investors and employees. Therefore, the failure of either agency to pass a universal fiduciary standard in order to provide the public with a simple, yet meaningful, expression of their rights and protections in their dealings with financial/investment advisers will be yet another in a growing list of government breaches of the public’s trust.

Notes
1.http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf
2.http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126431.pdf
3. DiFelice v. U.S. Airways, 497 F.3d 410 (4th Cir. 2007)
4. 29 U.S.C.A. Sections 1104(a)(1), (a)(1)(A)(i), and (a)(1)(A)(ii)
5. Restatement (Third) Trusts, Section 78 (Duty of Loyalty)
6. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9th Cir. 1982)
7. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975)
8. 8. Archer v. Securities and Exchange Commission, 133 F.2d 795, 803 (8th Cir. 1943)

Copyright © 2017 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and is not designed or 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.

 

 

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Eyes Wide Shut: Why the SEC Will Not and Cannot Adopt a Fiduciary Standard

Living is easy with eyes closed, misunderstanding all you see. – “Strawberry Fields Forever”

In recent appearances on Capitol Hill, SEC Chairman Jay Clayton and DOL Secretary Alexander Acosta pledged to work together on a fiduciary rule applying to stockbrokers and other financial advisers providing investment advice to the public. Both men are on record as saying any fiduciary rule must not curb the public’s access to advice or products. That’s all you need to know. Mr. Clayton and Mr. Acosta are clearly drinking the Kool-Aid supplied by the investment industry.

The investment industry has failed to provide any credible and court-admissible evidence that establishes their claims that the public would suffer access to advice. To date, the investment industry has produced nothing more than speculative and self-serving statements. And to be honest, they cannot produce any credible evidence until a meaningful fiduciary is implemented and experience either supports or disproves their theories. As far as access to products, the public’s best interests would be better served if many of the investment products currently available were completely removed, as they clearly are not in any investor’s best interests.

And yet, it appears that Chairman Clayton and the SEC have already made up their mind to oppose adopting any type of meaningful fiduciary standard, a standard that would simply require that stockbrokers and other financial advisers always put a customer’s best interests ahead of their own financial self-interests.  Adoption of a meaningful fiduciary standard by the SEC would simply be furthering the Commission’s vision and mission statements:

Vision Statement:  The SEC strives to promote a market environment that is worthy of the public’s trust and characterized by transparency and integrity.

Mission Statement: The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.

However, it can be argued that the failure of the Commission to adopt a meaningful fiduciary standard would be consistent with the SEC’s pattern of ignoring the needs and protection of the public. In 2o07 the Financial Planning Association won a lawsuit that it filed against the SEC to force them to enforce the registration provisions of the 1940 Investment Advisors Act against Merrill Lynch. In an attempt to resolve the dispute, the SEC had proposed the following disclosure in lieu of registration:

Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits and our salespersons’ compensation may vary by product and over time.

Once the court ruled against the SEC. the SEC withdrew the disclosure requirement. Despite subsequent calls for bringing back the disclosure to address current conflict of interest issues plaguing the investment industry, the SEC has not done so. One would think the SEC would re-institute the disclosure requirement to at least educate and warn the public, which would clearly be in furtherance of its mission statement.

Given the SEC’s dismal record in proposing protective measures for the public, one could argue that the SEC’s recent announcement is nothing more than posturing, nothing more than providing Congress with rhetoric to support its effort to stop the DOL rule. Some might consider that allegation harsh. However, a fair and realistic appraisal of the situation clearly leads to only one conclusion:

The SEC will not, and cannot, afford to create and adopt a meaningful universal fiduciary standard.

Before everyone grabs their torches and pitchforks, allow me to present the evidence supporting my position. As intimated earlier, my primary theory is that many of the investment products currently on the market would not pass a meaningful fiduciary standard. By “meaningful” fiduciary standard, I mean a fiduciary standard that is consistent with the standards set out in the Restatement (Third) Trusts (Restatement), especially Section 90, more commonly known as the Prudent Investor Rule.

I have recently written a couple of articles addressing the fiduciary duty of cost-consciousness, as set out in the Restatement. The current pricing platforms used by actively managed mutual funds and variable annuities raise legitimate questions as to whether such products would pass the Restatement’s prudence requirements. Quite simply, is the Commission willing to risk the wrath of Wall Street and the investment industry by honoring  its stated vision and mission statements and enact a meaningful fiduciary standard to protect the public and ensure fair and equitable treatment for all investors?

Actively Managed Mutual Funds
LPL, one of the nation’s largest independent broker-dealers announced twenty funds that will make up their new “fiduciary friendly” platform of mutual funds. LPL announced that the funds on the list may have “onloading” fees of up to 3.5 percent. Most have interpreted the referenced “onloading” fees as simply an attempt to avoid using the term “front-end” load.

Whatever you choose to call such front-end charges, the fact is that front-end fees are never “fiduciary friendly” since they automatically reduce an investor’s initial investment in a fund, placing them at a disadvantage and guaranteeing a reduced return on an equivalent return in a comparable fund that does not charge such front-end fees. When you also factor in the higher expense ratios and trading costs normally associated with actively managed funds, the result is usually a situation where the investor forever suffers significantly lower returns than a comparable passive, or index, fund.

Evidence of that fact can be seen by comparing the performance of American Funds’ Growth Fund of America (AGTHX)(American Funds was one of the fund families on LPL’s list) with a comparable index fund, in this case Vanguard’s Growth Index Fund (VIGRX). Both funds are classified as large cap growth funds by Morningstar.

According to the Morningstar Investment Research Center (MIR Center), as of July 14, 2017, AGTHX charged a front-end load of 5.75 percent, with an annual expense ratio of 66 basis points (1 basis point equals 1/100th of 1 percent) and an annual turnover rate of 31 percent. Since mutual funds are not required to disclose their actual trading costs, this paper will estimate a fund’s trading costs by using a metric created by John Bogle. The Bogle metric estimates a fund’s trading costs by doubling a fund’s stated turnover ratio, and then multiplying that number by 0.60. For example, the estimated trading costs of a fund with a turnover rate of 50 percent would be 60 basis points.

According to the MIR Center, VIGRX does not impose a front-end load, and has an annual expense ratio of 18 basis points and an annual turnover rate of 13 percent, or 13 basis points using the Bogle metric.

Assuming an initial investment of $10,000 and an annual return of 10 percent, and applying the annual expense ratio and trading costs for each fund, AGTHX would never break even with VIGRX. In fact, the additional return that AGTHX would have to achieve each of the first five years in order to just break even each year would be

Year 1 – 6.88%
Year 2 – 7.65%
Year 3 – 8.42%
Year 4 – 9.21%
Year 5 – 10.01%

The numbers produce two noticeable trends. First, even with less principal each year, AGTHX’s higher costs result in a lower comparable return each year. Second, the size of the deviation in returns, and thus the additional return needed to break even each year with the applicable benchmark, increases annually.

In deciding to recommend or select an actively managed mutual fund, the Restatement states that a fiduciary has a duty to be cost conscious. In establishing criteria for use in meeting this fiduciary duty, the Restatement sets out two important criteria, namely

[Fiduciaries], like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and cost for a particular level of expected return – or, inversely, the highest level of return for a given level or risk and cost.(1)

[A] decision to [recommend or select actively managed mutual funds] involves judgments by [a fiduciary] that: a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…(2)

The numbers shown above clearly indicate that the actively managed mutual fund has consistently underperformed a comparable index fund, raising clear questions of prudence. This under-performance should not be surprising, as the S&P Indices Versus Active (SPIVA) semi-annual reports have consistently reported that a large percentage of actively managed mutual funds fail to outperform their comparable benchmarks.

Other questions regarding AGTHX’s fiduciary prudence can revealed by evaluating the fund using the Active Management Value Ratio™ 3.0 (AMVR) metric. The AMVR evaluates the cost-efficiency of an actively managed mutual fund by comparing the fund’s incremental cost relative to the fund’s incremental return. The AMVR analyzes an actively managed mutual fund using four types of returns: nominal, load-adjusted, risk-adjusted and a return adjusted using Ross Miller’s Active Expense Ratio (AER) metric. The AER metric is becoming more significant in the forensic analysis of mutual funds, as it addresses the issue of “closet indexing.”

An AMVR analysis based on nominal returns was not done for AGTHX since nominal returns are of no significance with funds that levy a front-end load. In such cases , the fund’s load-adjusted return is the important return. That said, using data as of June 30, 2017 and VIGRX as the applicable benchmark, AGTHX failed to outperform VIGRX based on AGTHX’s load-adjusted, risk-adjusted and AER adjusted returns, resulting in a “cost-inefficient” designation for AGTHX.

Most AMVR analyses of various actively managed mutual funds that I have conducted have resulted in a “cost-inefficient” designation for a fund due to the fact that the fund either failed to outperform the relative benchmark, or the fund did outperform the relative benchmark, did produce a positive incremental return, but the incremental costs incurred in doing so were in excess of the incremental return, thereby resulting in a loss for an investor.

The fact that an increasing number of actively managed mutual funds are “hugging” their relative index or a comparable index fund is a fiduciary prudence issue that is gaining more attentions. Such “index huggers,” more commonly known as “closet index” funds, are generally cost-inefficient since their returns will generally track the returns of their relative, but their costs, in terms of both annual expense ratio and turnover trading costs, are usually significantly higher than those of comparable index funds. The issue of “closet indexing” is especially prevalent among large cap funds.

The failure of so many actively managed mutual funds to outperform their relative benchmarks and/or their failure to satisfy the cost-conscious fiduciary prudence standards established by the Restatement will create obvious legal issues under any meaningful fiduciary standard adopted by the SEC, or any other regulator.

Variable Annuities 
Another investment product that has created, and will continue to create, legal issues under the fiduciary duty of prudence is variable annuities (VAs). My articles on variable annuities are by far my most frequently read articles on both my blogs, “The Prudent Investment Fiduciary Rules,” and “CommonSense InvestSense.”

Should the SEC adopt a universal fiduciary standard, the primary issue that the they would have to face involving VAs is the clearly inequitable pricing platforms used by most (VA) issuers in assessing a VA’s annual fees. Even industry insiders have openly admitted that the pricing used by VA issuers is inequitable and needs to be changed.(3)

The pricing method drawing the most criticism is the VA’s use of inverse pricing in connection with the VA’s annual mortality and expense fee (M&E fee). A VA’s M&E fee is the cost assessed for the VA’s death benefit protection.

The problem with the M&E is that most VA issuers use a method known as “inverse pricing” to calculate the fee. “Inverse pricing” refers to the fact that the M&E fee is based on the accumulated value of the VA. Studies have shown that very few VA owners ever need to rely on the death benefit given the historical performance of the stock market.

So the fact that a VA owner will be paying a higher M&E fee exactly when the value of the VA is such that they cannot use the death benefit is what raises a primary fiduciary  issue with the product. Industry expert Moshe Milevsky conducted a landmark study of the VA industry’s pricing in connection with the death benefit.

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.(4)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.(5)

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.(6)

The fiduciary issues created by such inequities in such a pricing differential involving the cost and inherent value of the VA’s death benefit are obvious. Even now, with the debate over the DOL’s new fiduciary standard, the M&E pricing issue has been recognized and sales have declined dramatically.

The VA M&E pricing issue involves more than just the cost-inherent value issue. Each additional 1 percent of investment fees and costs reduces an investor’s end return by approximately 17 percent over a twenty year period. Given the fact that a VA’s M&E fees are the largest part of a VA’s overall cost, usually in the range of 2.5-3 percent, investors can easily find themselves in a situation where the M&E fee alone will result in them losing 50 percent or more of their end returns. Toss in an additional 1 percent for the VA’s investment account fees and another 1 percent for a “living benefit” rider, five times 17 percent….That is why a popular saying in the VA industry is that “variable annuities are sold, not bought.” It would be extremely difficult for the SEC or any regulator to justify those conditions and results as being in the “best interest” of any investor under any meaningful fiduciary standard.

Conclusion
To revise a statement that I made earlier in this paper:

The SEC will not, and cannot, afford to create and adopt a meaningful universal fiduciary standard because far too many products currently on the market are not “fiduciary friendly.”

The evidence overwhelmingly shows that some of the investment industry’s most successful products will never pass scrutiny under a meaningful fiduciary standard, at least not without major revisions. Therefore, it is highly unlikely that the SEC will stand up and risk the ire of Wall Street and the investment industry by enacting a meaningful fiduciary standard that is consistent with the fiduciary standards set forth in the Restatement (Third) of Trusts. As the saying goes, “ wise owl does not poop in his own nest.”

The chances of the SEC adopting a meaningful fiduciary standard are even less when one considers the SEC’s recent track record in being proactive in protecting the investing public. Far too often the SEC’s attitude has been to protect the investment industry, while treating the investing public as the proverbial “red-headed stepchild.”

For all the stories I have read about the industry’s speculative and meritless allegations of  impending doom-and-gloom that any fiduciary standard will create, as well as the empty rhetoric from Secretary Acosta and Chairman Clayton that the fiduciary standard is a priority, I think about a quote that I have always used in my closing argument at trial. The quote, from the late General Norman Schwarzkopf, sums up my whole opinion about the debate over the fiduciary standard, and accurately states the challenge facing both Secretary Acosta and Chairman Clayton.

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

Notes
1. Restatement (Third) Trusts, Section 90 cmt f
2. Restatement (Third) Trusts, Section 90 cmt h(2)
3. John D. Johns, “The Case for Change,” Financial Planning (September 2004), 158
4. Moshe Milevsky, “Confessions of a VA Critic,” Research Magazine, January 2007, 42-48
5. Milevsky
6. Milevsky

© 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 404c, Annuities, closet index funds, DOL fiduciary rule, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investments, pension plans, prudence, retirement plans, RIA, RIA Compliance, securities compliance | Tagged , , , , , , , , , , , , , , , , , ,

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.

Conclusion
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.

Notes
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.

Conclusion
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.

 Notes
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.

Notes
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.

Conclusion
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 , , , , , , , , , , , , , , , , , , , , , , ,