Whenever plan sponsors and plan advisers talk about 401(k) litigation, they always point the finger at those bad ‘ol ERISA plaintiff attorneys. Since I am one of those bad folks, I respectfully disagree with such sentiments. I respectfully suggest that plan sponsors should look in the mirror to see the real party for such litigation. As the famous comic strip, “Pogo,” once said, “we have met the enemy and he is us.”
Whenever I talk with a CEO and or a 401(k) investment committee, this is the first graphic I show them. Most plan advisers insist on plan sponsors agree to an advisory contract that contains a fiduciary disclaimer clause. Many plan sponsors are not aware that they have agreed to such a provision since they are usually set out in legalese. But they are usually there.
When a plan sponsor agrees to such a clause, it waives important protections for both itself and the plan participants. With a fiduciary disclaimer clause, securities licensed advisers can claim to be subject to Regulation “Best Interest” (Reg BI) rather than the more demanding duties of loyalty and prudence required under a true fiduciary standard.
Reg BI claims that it requires brokers to always put a customer’s best interests first, including considering the costs associated with any and all recommendations. The Reg BI turns around and allows brokers to only consider “readily available alternatives,” which the SEC considers to be the cost-inefficient and consistently underperforming actively managed mutual funds and various annuity products. In whose best interests?
Unless a plan sponsor properly performs the investigation and evaluation required under ERISA, this usually results in 401(k) litigation and the plan sponsor settling for a significant amount. As we discussed in a previous post, when you consider that all of this can be easily avoided by a plan sponsor by performing a cost-efficiency analysis using our free Active Management Value Ratio, you have to wonder why plan sponsors do not better protect themselves by simplifying their plans and ensuring that they are ERISA-compliant.
My experience has been that most plan sponsors create unnecessary liability exposure for themselves due to a mistaken understanding of their true fiduciary duties. “The CommonSense 401(k) Plan”™ provides a simple solution that reduces both administration costs and potential liability exposure, resulting in a win-win situation for both plan participants and plan sponsors.
So, for plan sponsors and plan advisers, the next time you point a finger at ERISA plaintiff’s attorney and blame us for the number of 401(k) litigation cases, remember the words of my good friend, Charles Nichols, when you point at us, three of your remaining fingers point back at you. Then contact InvestSense for a free “The CommonSense 401(k) Plan” consultation at “CommonSense InvestSense.” (investsense.com)
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
I have looked at dozens of retirement committee meeting minutes working with both public and ERISA retirement plans and I have seen little or no discussion of vendor due diligence around lawsuits and regulatory issue.
When firms hire an employee, they usually do a background check. From SHRM”
A background investigation generally involves determining whether an applicant may be unqualified for a position due to a record of criminal conviction, motor vehicle violations, poor credit history, or misrepresentation regarding education or work history. [i]
Given this exhaustive process for one new hire it makes sense to run the same type of background check on vendors for the employee’s retirement plan and It can be argued is the plans fiduciary duty to run one on each vendor.
While a violation may not be an immediate reason to disqualify and terminate a vendor, it would be a good fiduciary process for the plan to ask the vendor to explain the violation and why it does not affect their ability to serve the plan.
A lot of plan fiduciaries would not be surprised by 401(k) litigation if they had followed this easy fiduciary process. Many of the same firms caught by the SEC for share class violations for retail and other institutional funds are doing the same thing in 401(k) and it is showing up in litigation. Many of these firms avoid fiduciary responsibility in their contracts multiplying this risk.
Violation tracker quickly shows: Prudential has 19 investor protection violations with fines totally over $744 million.[ii] Wells Fargo has 223 overall violations 93 investor protection violations. Bank of America 264 overall violations 119 investor protection violations.
.Going to the SEC website under litigation you can easily find the following more detailed violations.
SEC Merrill Lynch (B of A) – Share Class Violation April 17, 2020
SEC Wells Fargo (Bridgehaven)Share Class March 11, 2018
SEC Morgan Stanley (Greystone)Share Class November 7, 2019
SEC TIAAJuly 2021 misleading statements failure to disclose conflicts of interest [i]
SEC MML Mass MutualSept 21 Revenue Sharing Share class violations
SEC VALIC Financial Advisors Inc. AIG-VALICJuly 28, 2020 Revenue Sharing Share class violations
SEC VOYA Financial Advisors Inc ING-VOYADec. 21, 2020 Share class Revenue Sharing Share class violations
SEC PRUCO Securities, LLC (Prudential)Dec 23, 2020 Rev Sharing Share class violationsFINRA PIMS June 2020
SEC PRINCIPAL Securities, Inc.March 11, 2019 Revenue Sharing Share class violations
SEC TRANSAMERICASept 30, 2020 fee gauging TA FINRA Share Class Variable 2020 annuities2014 Fee Gauging
A prudent ERISA fiduciary should be aware of these violations, and/or their consultants/attorneys should have brought this to their attention. They should also be aware of any 401(k) litigation each vendor is involved in both directly and indirectly.
Each vendor’s contracts should state they take fiduciary duty as to not shift it back to the plan.
A background check for every vendor is essential for fiduciaries.
Crypto, trying to bribe its way into 401ks via Congress and with providers like Fidelity, has exposed a non-transparent dark area of 401(k) that has been on the back burner – brokerage windows. A typical plan has 12 to 16 main options, but a brokerage window could add hundreds of additional choices that so far have escaped any oversight. Fidelity stated they would put crypto as a main option and prompted this response from the DOL
“The plan fiduciaries responsible for overseeing [cryptocurrency] investment options or allowing such investments through brokerage windows should expect to be questioned about how they can square their actions with their duties of prudence and loyalty.”[i
The DOL advisory council put together a report on brokerage windows that basically said they are so immaterial, that the DOL needs to give little or no oversight to them since those in the brokerage window are aware of the additional risks.[v]
A report cites PSCSA that
23.2 percent of all retirement plans offer a brokerage window, and nearly 40 percent of those with more than 5,000 participants do. Even though brokerage windows are being offered in many plans, participants do not use them widely only 1.5 percent of plan assets are invested through brokerage windows. DOL states that custodians saw a usage ranged from .03 percent to 3 percent. [vi]
Because of their size, less attention has been paid to brokerage windows both by the DOL and the plaintiff’s bar. But with the declaration by Fidelity to offer crypto as a main option within plans and the DOL doing its job by sounding concerns, people realized that there could be crypto investing already going on in brokerage windows, with most plans not having a clue.
Fidelity, who is the largest runner of brokerage windows and who cut the deal with bitcoin to put them on their platform, are most likely receiving millions of undisclosed dollars from the crypto crowd.
Crypto is pouring millions into DC lobbying, and seems shocked that DOL did their job and did not roll over like they did with private equity investments under Trump.
Bloomberg writes that
Under that guidance, which the DOL issued last month, employers could be responsible for risky crypto trades their workers make in workplace 401(k)s. The DOL’s employee benefits enforcement agency will launch what it’s calling “an investigative program” that requires plan officials to “square their actions with their duties of prudence and loyalty” if they allow crypto investments in self-directed accounts, according to the guidance.[vii]
“This is a very damning statement about brokerage windows,” said Lisa Tavares, a partner at Venable LLP and a former IRS attorney.”
Since almost all brokerage windows have excessive fees and many have excessive risks that do not pass fiduciary scrutiny, this opens up almost any plan with a brokerage window to potential litigation.
Leading plaintiffs firm Keller Rohrback LLP is investigating whether employees and retirees have paid unnecessary fees in connection with their use of brokerage windows such as excessive fees, selecting funds based on the amount of fees shared with the brokerage firm, and selecting more expensive share classes despite the availability of less expensive classes of the same fund. They have targeted particular large firms like Continental Airlines, Kimberly-Clarke, Lilly, and Caterpillar looking for plaintiffs.[viii]
In the article, “401(k)s with Bitcoin Should Expect Lawsuits: Lawyers,” trade publication “Ignites” quotes Jerry Schlichter as saying that
Any employer who would follow the Fidelity lead by offering cryptocurrency and 401(k) plan is exposing itself to very serious risk of a fiduciary breach…. As an unproven, highly volatile investment, Bitcoin would test the prudence standard under the Employee Retirement Income Security Act….The account will carry a fee of up to 90 basis points, plus undisclosed commission fees, which would be 20 times as much as a simple index fund.[ix]
The defense bar is trying to talk up a structure the digital accounts to qualify for 404(c) protections. Schlichter, however, suggested that 404(c) protections would not provide a safe harbor anyway. He pointed to a Supreme Court decisionhanded down in January that found that plan sponsors could not escape their responsibility for allowing imprudent investments in their plans even if they feature them alongside prudent ones. Schlichter represents the plaintiffs in that case, the plan participants in Northwestern University’s 403(b) plan.Quoting Schlichter,
“[The Supreme Court] said, ‘No, the employer plan sponsor has the duty to furnish only prudent options,’ and the same applies here.'”
Any 401(k) plans with a brokerage window will be subject to severe fiduciary liability unless they can prove they have provided 100% prudent options. This will most likely lead to much more litigation and many more settlements, as the cost of proving 100% prudent options will be extremely expensive.
50 percent of all 401(k) assets are in target date funds. I believe Target Date Funds were created to sustain higher fees. The least transparent Target Date Funds are those that are not SEC registered mutual funds. Many are in poorly state regulated annuities either in whole or in part. Many are in poorly state regulated Collective Investment Trusts (CIT)s Many CIT’s can hide private equity or annuities and their many hidden fees and risks. Many, if not most, CIT based Target Date Funds and all annuity TDF’s are a fiduciary breach based on the higher risks alone, not to mention the excessive fees.[i]
Weak Regulation There is a general assumption that CIT’s are regulated by the Federal Government Office of Comptroller of the Currency (OCC). Some CIT’s are regulated by the OCC while many others are regulated by one of 50 state bank regulators. This allows CITs to choose their own state regulator who may have the laxest oversight. [ii] While the SEC mutual fund regulations are not perfect, they do control for a lot of risks and provide a good amount of transparency
Prudential Day One Target Date funds provide this disclosure to plans:
Unlike mutual funds, the Day One Funds, as insurance company separate accounts or collective investment trusts, are exempt from Securities and Exchange Commission registration under both the Securities Act of 1933 and the Investment Company Act of 1940 but are subject to oversight by state banking or insurance regulators, as applicable. Therefore, investors are generally not entitled to the protections of the federal securities laws.[iii]
Principal provides this disclosure:
The CITs are not mutual funds and are not registered with the Securities and Exchange Commission, the State of Oregon, or any other regulatory body.
The Collective Trust and the Funds intend to qualify for the exclusion from the definition of an “investment company” under the 1940 Act provided for by Section 3(c)(11) of the 1940 Act. The Section 3(c)(11) exclusion is available for collective investment funds maintained by a bank consisting solely of assets of certain employee benefit plans. Accordingly, Participating Trusts will not have the benefit of the protections afforded by the 1940 Act (which, among other things, requires investment companies to have governing boards of directors with a majority of disinterested directors and regulates the relationship between the adviser and the investment company). The offering of units of the Funds (each, a “Unit”) has not been registered under the U.S. securities laws or the laws of any applicable jurisdiction. Therefore, Participating Trusts will not have the benefit of the protections afforded by the Securities and Exchange Commission (“SEC”) under the Securities Act of 1933 (the “1933 Act”) (which, among other things, requires specified disclosure in connection with the offering of securities). Neither the SEC nor any state securities commission has approved or disapproved of the Units or determined if this document is accurate or complete. Any representation to the contrary is a criminal offense
In these cases, it appears these target date funds are avoiding SEC and any kind of federal regulation. The only state regulator with any standards close to the SEC is New York and most of these funds avoid NY regulation whenever possible.
How can any fiduciary subject to Federal ERISA laws use for its main investment options target date funds that go out of their way to avoid Federal oversight?
Toxic Assets A major reason to avoid SEC oversight is to put in investments which are not allowed in SEC registered mutual funds because of risk. The other reason is to load up on assets with hidden fees which will not be disclosed under the current weak regulation.
Private equity, along with other illiquid contract investments like hedge funds, private debt, real estate is a potential fiduciary time bomb for plans and their participants. In target date funds even a small allocation to a Target Date Fund, with the excessive risk, lack of outperformance and excessive fees seem to make it a fiduciary risk. [iv]
A disclosure from Principal:
A differentiating aspect…..is exposure to alternatives (hedge fund strategies).[v] ….. Given the managers approach to asset allocation (more equities and alternatives)…. Exposure to nontraditional (commodities, natural resources, and real estate) and alternative (hedge fund strategies) asset classes is a differentiating aspect from a style perspective relative to the peer group
Principal LifeTime Hybrid CITs may invest in various types of investments including Principal Funds, Inc. institutional class shares, Principal Life
Insurance Company Separate Accounts and other collective investment trusts and mutual funds.The risks associated with derivative investments include …that there may be no liquid secondary market, Investing in real estate securities, subjects the Fund to the risks associated with the real estate market (which are similar to the risks associated with direct ownership in real estate), including declines in real estate values, loss due to casualty or condemnation, property taxes, interest, rate changes, increased expenses, cash flow of underlying real estate assets, regulatory changes (including zoning, land use and rents) and environmental problems, as well as to the risks related to the management skill and creditworthiness of the issuer.
Like high-risk hedge funds Prudential, Principal and others have the contractual right to put up gates and restrict liquidity if they are downgraded or in danger of default. They can refuse to give the plan/participant their money at any time which would be illegal in a SEC registered mutual fund
Annuities I spent 7 years at Transamerica making insurance annuity 401k products Anytime an insurance company puts something in an annuity form, they take ownership of the underlying securities put it on their balance sheet and squeeze out another 150 bps or more in spread fees. Anytime something is put in an insurance company Separate Account, same thing they take ownership and lock in a spread.
These annuities do not have SEC mutual fund oversight, and the plan does not own the underlying SEC registered securities, the insurance company does. I make the argument that any annuity is a fiduciary breach. [vi]
Prudential Day One Funds may be offered as: (i) insurance company separate accounts available under group variable annuity contracts issued by Prudential Retirement Insurance and Annuity Company (PRIAC),
Sub-Advised Investment Options include Separate Accounts available through a group annuity contract with Principal Life Insurance Co.
Fees Target Date Funds are so opaque that the actual fees and profits are hard to pin down. I estimate that many could approach 200 basis points or more.
Principal Target dates have 13 underlying funds 5 insurance company separate accounts (annuities), 4 CIT’s, 4 proprietary mutual funds, for a total of 25 share classes.
The disclosed fees are even way above most providers, so any plan using these is not trying to minimize fees.
Conclusion Any plan sponsor who invests in one of these black hole CIT funds deserves to be sued. I guess that in many cases there is a so-called consultant receiving a huge undisclosed insurance commission.
One of my favorite disclosures:
The ultimate decision as to whether a Principal LifeTime Hybrid CIT is an appropriate investment option for a plan and whether a target date fund can serve as a QDIA belongs to the appropriate retirement plan fiduciaries.
interpret this disclosure as the insurance company way of saying “if you are stupid enough to buy our high fee high risk products, it is on you, not us.”
Annuities issued by a single insurance company are a Fiduciary Breach. They can be called guaranteed income, they can be called GIC’s or fixed accounts, or index annuities. I am focused on the institutional annuity products mostly used in 401(k)s. There are many more fiduciary breaches in retail and variable annuities, as noted by attorney James Watkins in his recent article.
There are breaches in institutional annuities for 4 basic reasons
Single Entity Credit Risk
Single Entity Liquidity Risk
Hidden fees spread and expenses
Structure -weak cherry-picked state regulated contracts not securities and useless reserves
A 1992 Federal Reserve paper notes that the so-called insurance safety net is much weaker than most realize. [i]
Annuities are in the news as insurance companies are pouring millions of dollars into lobbying and PR and advertising trying to trick people into buying them.
The insurance industry spends millions of dollars trying to abolish and weaken fiduciary standards because they do not come close to meeting them.
Insurance companies are especially frustrated with 401(k) plans because they have not only the strongest fiduciary standards, but an enforcement mechanism in 401(k) litigation. While they have lobbied the US Department of Labor to ignore most of their enforcement duties on excessive fees on 401(k), they have not been able to block court action, and the latest Supreme Court ruling has reinforced this.
Annuities in 401(k) plans have traditionally been in 401(k) plans though a stable value of fixed annuity option. [ii] In recent years they are trying to expand into hiding annuities in target date funds,[iii] mostly under the guise of Lifetime Income.[iv]
The Insurance industry’s huge push into 401(k) has even had some plan fiduciary consultants sounding words of caution. A commentary in Benefits Pro by Mitch Shames is titled “Annuities: The Straw That Breaks the Back of Retirement Plan Fiduciaries.”[v]
Annuity contracts, however, are not investment securities. Instead, they are individually negotiated contracts entered into between an insurance company and the annuity-holder. …… the fiduciary will also need to be a prudent expert in the selection of the annuity. That is a pretty tall order. Retirement plan fiduciaries are on notice. Annuity contracts may be the straw that breaks the back of the fragile fiduciary infrastructure employed by plan sponsors under ERISA.[vi]
Single Entity Credit Risk Single Entity Credit Risk – Diversification is one of the most basic Fiduciary duty and annuities totally ignore this. Like a single stock or a single bond is a clear fiduciary breach so is an investment 100% reliant on one entities credit like an insurance contract.
For over 20 years fiduciaries in the know, like large 401(k) plans, fled fixed annuity products backed by the general account of a single insurance company. This was due to concerns about single entity credit and liquidity risk. Many attribute this to the 1992 and 1993 defaults by Executive and Confederation Life, as documented by the Federal Reserve Bank 1992 article.[vii]
In 2005 AIG was AAA rated and some in the trade press said that AIG was as safe as the Government by 2008 it was in default. In 2008 Federal Reserve Chairman Ben Bernanke said that “workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk that their stable-value funds would decline in value would have seen that insurance disappear.”[viii] Many investment professionals believe that a plan sponsor is taking a severe fiduciary risk by having a single contract with any one entity, such as AIG. It can be argued that a plan is taking less risk by assuming that the single insurance company backing the stable value option is too big to fail and has an implied government guarantee.
The Federal reserve for several decades bought fixed annuities in their stable value option in there 401(k) option for their employees. They limited credit exposure to 5% per insurance company. In the late 2000’s there were not the 20 issuers needed for diversification so they shut the fund down. Even the few diversified annuity structures still have 25% or 33% single entity exposure which is considered high by fiduciary diversification norms.
Taking 100 perentsingle entity credit risk is a clear breach of fiduciary duty.
Single Entity Liquidity Risk Single Entity Liquidity Risk – A fiduciary managing a bond portfolio sells a bond when it is downgraded to a level allowed in the investment policy. Most Annuities are not allowed to be sold when they are downgraded. They have no liquidity if the firm is downgraded multiplying the credit risk as a participant has to ride it down to default.
Noted Morningstar analyst John Reckenthalrer said in April 2022 that in selecting 401(k) investment options, “inappropriate are investments that don’t price daily.” [ix]
Annuities do not price or mark to market daily. There is a secondary market for retail annuities provided by firms like JG Wentworth and Peachtree, which many times only pay 80 percent on the dollar. So, if you bought an annuity and wanted to sell it the next day on the secondary market, you would take a 20 percent loss. There are annuity products that provide some limited liquidity, what they call benefit responsive, but is always a major fiduciary risk.
Hidden fees spread and expenses Prudential in a 2013 conference documented by Bloomberg bragged that they had secret hidden spread fees of over 200 basis Points.[x]
This loophole allows insurance companies to hide as much 2% or 200 basis points (bps) in yearly spread profits. I was quoted in the Wall Street Journal’s Marketwatch, stating that
“These excessive profits, even if called spread, act like fees and are used like fees,”[xi]
In addition they continue to pay commissions out of the hidden spread which drive even more sales.
The National Association of Government Defined Contribution Administrators, Inc. (NAGDCA) in September 2010 created a brochure with this characterization of insurance company general account stable value that got beyond the high risks and right to fee disclosure.
Due to the fact that the plan sponsor does not own the underlying investments, the portfolio holdings, performance, risk, and management fees are generally not disclosed. This limits the ability of plan sponsors to compare returns with other SVFs [stable-value funds]. It also makes it nearly impossible for plan sponsors to know the fees (which can be increased without disclosure) paid by participants in these funds—a critical component of a fiduciary’s responsibility.[xii]
It is hard to comprehend why the DOL lets these products escape disclosure. However, there is already ERISA litigation in which spread fees have been important in settlement negotiations.
Structure -Weak Cherry-Picked State Regulated Contracts and Useless Reserves When you purchase an annuity, you do not get to own any securities, you just get a piece of paper.
Whereas securities (and the firms issuing, offering or underwriting the instruments) are governed by the federal securities laws and regulated by the Securities and Exchange Commission, insurance companies and the contracts they enter into are governed by the States – 50 different regulators and bodies of law. Once again, the variety can be staggering. This is the world that retirement plan fiduciaries are being forced into. [xiii]
A 1992 Federal Reserve paper notes that the so-called insurance safety net is made of 50 different state regulators with a wide variety of regulations and is much weaker than most realize. This allows companies to shop for insurance regulation among the 50 states to find the ones that have the softest regulations. [xiv] In 2017, The European Union showed concern with the weakness of state regulators of insurance companies. [xv]
Investors are mostly unaware of this risk based on flimsy state guarantees which the Federal Reserve has said have little worth. [xvi] These guarantee fund balances are typically a joke with $0 as they pass the hat to other insurers if one goes under.
Required Fiduciary Questions What should a fiduciary document and become comfortable with before investing in an annuity.
1.Which state issues the annuity, what is their record, do they have conflicts of interest with the insurance company?
2.What is their minimum capital requirement in basis points for this annuity product in the state your contract is issues in?
3.What is the current solvency of that states guarantee pool.
4. Get full fee disclosure all internal spreads (200+) before expenses and then with expenses and profits broken down?
5. Does the Annuity contract have a downgrade provision to get out if the company is downgraded?
All annuities flunk at least one of these fiduciary tests, most flunk all. By and large the Fortune 500 largest US Corporations have avoided these insurance company products in their 401(k) plans since 1992. This is not because of fear of regulators, but because of fear of lawsuits filed by employees under the Employee Retirement Income Security Act of 1974 (ERISA). Thus, many of these non-transparent insurance products are in smaller company plans which are not cost effective for plaintiff bars to litigate individually. However, as litigation goes downstream there are over 9 thousand plans from $100mm to $3 billion out of the top 500 many of which have annuity assets. It is these mid to large plans who need to resist the annuity marketing push into guaranteed income mostly hidden in target date funds.
[i] Pg. 6 Federal Reserve Bank of Minneapolis Summer 1992 Todd, Wallace SPDA’s and GIC’s
Target Date Funds now are above 50% of all 401(k) assets.[i] They are the most non-transparent plan investment option and the easiest to hide fees and play performance games. They are also the dominant default option or QDIA (Qualified Default Investment Alternatives) resulting in the highest level of fiduciary responsibility. Despite the high level of fiduciary risk, they are specifically designed to avoid accountability and thus need the most scrutiny.
A 2021 study shows that in general Target Date funds cause participants to “lose 21%” over career to primarily excessive fees from proprietary funds.[ii] A 2020 study finds that asset managers exploit reduced investor attention (i.e. lack of transparency) to deliver lower performance.[iii]
HISTORY The history of the Target Date Fund, I believe, is mainly a story about Fidelity. I think around 2002 they saw Vanguard and indexing as their biggest threat. Fidelity needed a new vehicle to hide the fees for active mutual funds and created the Target Date Fund.
With heavy lobbying by Fidelity, in 2006 the Pension Protection Act was passed. This act allowed for auto-enrollment of target-date funds into defined contribution plans and set the stage for QDIAs (Qualified Default Investment Alternatives), which strongly supported the growth of these funds.[iv]
Fidelity had Target Date Funds ready to go before the legislation was passed and dominated in market share immediately, and still keep the highest levels today. This gave them basically a 10-year ride from 2006-16 in which they could load-up their higher fee active funds in target date funds with little or no pushback. Starting around 6 years ago there has been a shifting inside Fidelity’s target date funds toward greater indexing.
USING THE RECORDKEEPER After choosing a record keeper or administrator, most plans automatically default to the Target Date Funds of that company. A prudent process would be to have a competitive bid, but most 401(k) committees make selections based on informal processes and relationships.
Many times, the target date and administrative fees are commingled in the Target Date funds using revenue sharing to create a total lack of transparency.[v]
This record keeping default fuels the 2021 study showing that Target Date funds cause participants to “lose 21%” of their end-returns over their career due primarily to excessive fees from proprietary funds [vi]
A 2020 study found that the average higher-cost actively managed target date funds failed to perform as well as the cheaper indexed competition in the 2015-2019 period.[vii] Some of the actively managed funds did very well in relative terms, but most did not. We found that past performance is only weakly predictive of future performance. The implication is that even an active fund with a superior record has an expected future return below the passive alternative TDFs.
However, even within a record keeper’s Target Date Fund selections, there can be a wide variety of fee levels (especially with market leader Fidelity) in which 401(k) committees can make better fiduciary decisions. The burden is on the plan fiduciary to show why they are not selecting an index fund for the Target Date Fund the QDIA.
HIDING HIGH RISKS & FEES IN TARGET DATE FUNDS The least transparent Target Date Funds are those that are not SEC registered mutual funds. Many are in poorly state regulated annuities either in whole or in part. Many are in poorly state regulated Collective Investment Trusts (CIT)s. [viii] There are a few good CITs like the Fidelity, Vanguard, T. Rowe Price that are clones of their SEC mutual funds at a lower cost. Many CIT’s can hide private equity or annuities and their many hidden fees and risks. [ix]
Many, if not most, CIT based Target Date Funds and all the annuity TDF’s are a fiduciary breach based on the higher risks alone, not to mention the excessive fees.
GAMING THE BENCHMARK Many plans rely on consultants to guide them in the selection of Target Date Funds. However, some consultants have conflicts in which they are compensated more for high fee non-index funds in backdoor payments. Plans blaming consultants on poor Target Date Fund choices does not absolve them from fiduciary liability, but in some cases they have been able to get conflicted consultants to pay a portion of the settlement. [x]
High fee Target Date Funds typically justify their existence by some manipulation of a benchmarks. They may hold investments which are not in the benchmark, which create different performance and risk characteristics. They may use different allocations, mostly to higher equity positions, to create the appearance of higher returns.
A 2020 study shows Target Date Funds ‘Create a Lack of Accountability”[xi] For example a 2040 T. Rowe or American Fund can appear to outperform a 2040 Vanguard fund because it has a 90/10 equity allocation compared to 80/20 with Vanguard. “Target Date Fund managers engage in fee-skimming by charging higher fees on the less observable, more opaque underlying funds” [xii] Opaque funds can be illiquid high-risk alternatives like private equity and hedge funds & annuities.
In some cases, the courts have given active managers the benefit of the doubt on their claim that it is conceivable they could outperform index plans, especially in down markets. The validity of this market-based argument has become harder. The recent Supreme Court decision letting the appeal in Brotherston vs Putnam Investments, LLC stand upholds the use of index funds for benchmarking purposes in calculating damages – regardless of performance.[xiii]
PLAN ACTIONS Plans should always document in their 401(k) plan minutes the following regarding Target Date Funds:
The plan’s investment policy statement should include provisions on selecting and monitoring Target Date Funds. Does it address each asset class involved in the plan including inside the Target Date Funds?
Each asset class in each Target Date Fund should be fully evaluated in terms of risk, fees, and performance as if they were a standalone option.
Assets that are not SEC registered mutual funds or registered securities such as private equity, annuities need additional scrutiny and documentation.
Additional documentation, including a Request For Proposals (RFP), should be required if the plan is using a recordkeeper vendor’s proprietary Target Date Funds.
Select an appropriate benchmark to evaluate each asset class in the funds. Compare and justify the attributes of your fund if it has differences with the benchmark
Understand the different fees and compare fund family fees, bearing in mind that Target Date Funds have multiple layers of fees.
Do a RFP for Target Date Funds at least every 5 years.
Carefully document the reasons that the fund was selected.
Regularly monitor the funds.
Document any and all reasons for not removing retained funds if performance has lagged peer funds.
Target Date Funds are now above 50% of all 401(k) assets.[xiv] They deserve a 50% level of fiduciary oversight or even more because of their lack of transparency.
Floodgates are opening after US Supreme Court Northwestern 403(b)Case. [i] Most Hospitals not affiliated with public universities are subject to ERISA laws. Hospitals tend to have a higher percentage of high fee funds and a much higher risk of litigation.
Why are hospitals at such high risk? My take is that the 403(b) culture with its mix of ERISA and non-ERISA plans tends to have higher fee providers especially those associated with insurance companies. My other theory is that Hospitals face so much litigation on health care issues that this litigation is not seen as material by senior management. GAO recently did a report confirming that 403(b) s are not as sensitive to fees. [ii]
Here is the list of the 21 ERISA class actions I have found against hospital and health care 403(b)s and 401(k)s. Columbus GA Regional Hospital, Aurora Health WI Iowa Healthcare, Henry Ford 401k , Henry Ford 403b, Spectrum Health, Mercy Hospital Health IL Kalenda NY Barnabas Health. Rush University Medical Center, MedStar Health MD, Boston Children’s Hospital Corporation, Froedherdt WI, B.Braun Medical Inc.PA, Allina Health plan, Emory Healthcare, Bon Secours. Settlements I have found include Norton Ky ($5mm), Southcoast MA Hospitals Group ($2mm), Bronson Healthcare ($3mm), Novant Health ($32mm).
Many hospitals do not have independent consultants and one Lockton actually paid $2.5mm of the $5mm Norton Hospital settlement. [iii] Many hospitals still use revenue sharing which is a magnet for litigation. [iv] Hospitals are also high users of annuities. [v]
For most hospitals who have not paid attention and lowered fees already substantially it is only a matter of time before they face litigation. Even larger physician groups will soon be subject to litigation as well. Plans doing half fixes will not avoid litigation and some who have already settled may be sued a 2nd time.
401(k) Revenue sharing is a scheme that is sold to 401(k) plans sponsors who are too cheap to pay the administrative costs out of company funds, and thus are willing to trick participants into paying for it by an increase in fees in high-cost mutual funds and even higher cost annuities.
Heavy industry lobbying has kept this practice barely legal. However, I see Revenue sharing alone as a sign of a fiduciary breach since I have never seen it documented correctly, which turns into a shell game that increases fees, which has been confirmed in a 2021 study by experts from the Federal Reserve and leading Universities. Higher fees are not associated with better performance; to the contrary, “The future performance of revenue-sharing funds is weaker than that of non-sharing funds. The bulk of the under-performance is driven by higher fees, though revenue sharing funds display lower performance even after accounting for fees.”[i]
Revenue sharing does not hold up during litigation and this has been confirmed by Fiduciary Liability Insurance industry which put much higher litigation risk on plans with revenue sharing and either denying coverage or raising rates significantly. [ii]
There is no reason to go through the complicated non- transparent contortions of revenue sharing record-keeping if there is nothing to gain. In some cases, the rebates may be delayed, giving the float on the money. It is also unclear where rebates go if a participant leaves or transfers out of the fund. There is little or no accountability as the recordkeepers has unlimited ways to divert these rebates toward administrative expenses they set and control.
There are other forms of hidden revenue sharing in and out of 401(k)s such as shelf fees that firms like Wells Fargo require a manager to pay over $500,000 to just be considered. [iii]
The burden is on the plan and the recordkeeper to provide a full and transparent accounting of the entire revenue sharing process which we have not seen Revenue sharing will continue to be a litigation magnet.
Many if not most 401(k) consultants for 401(k) plans under $1 billion have serious conflicts of interests which in itself can be a fiduciary breach and contribute to excessive fees. While the number of conflicted consultants and level of conflicts in mega plans is still significant it is less prevalent. A Plan Fiduciary with a conflicted consultant takes on much greater fiduciary risk of getting sued.
Attorney James Watkins states that Consultants/Advisors recommending cost-inefficient/imprudent investment options to a plan sponsor, knowing that the plan is held to a fiduciary standard, violates duty of fair dealing, which is actionable as a breach of contract per SCOTUS (Shaw v. Delta Air Lines).
Jennifer Cooper published a report on the US consultant industry in 2013 based on the ADV report filed by RIA’s.[i]
They found numerous conflicts. The most common being dually registered consultant/advisors who are also brokers or have affiliated brokers. [ii]
Dr. Nicole Boysen of Northeastern University in Boston has written a paper that shows consultant/advisors (RIAs) that both charge fees and commissions (dual registration) use higher fee lower performing mutual fund families that kick them back the most in “revenue sharing” Boysen created a list of high fees underperforming mutual funds preferred by dual registered RIAs, which include the American Funds, JP Morgan, MFS Fidelity, PIMCO.[iii] Conflicted consultants are also known to manipulate statistics using cherry-picked benchmarks to make higher fee funds look better.
From a Forbes story by former SEC attorney Edward Siedle:
In recent years the U.S. Department of Labor, the Securities and Exchange Commission, and the General Accountability Office have all advised companies sponsoring retirement plans that conflicts of interest related to investment consultants to plans are widespread and that these conflicts have resulted in reduced returns, as well as higher fees for retirement investors. [iv]……..
While every investment consultant I’ve ever met claims to provide objective, independent advice, the industry is rife with conflicts. If the gatekeepers vetting and recommending money managers to plans are corrupt, then the plan’s entire investment program may be tainted. [v]…………
In fact, consultant conflicts are more pervasive than ever today and, with the growth of alternative investments, consultant secret profits, as well as damages, related to these conflicts have skyrocketed. Most plan sponsors, even the largest, haven’t a clue about the abuses and, unfortunately, aren’t looking for answers. [vi]
The SEC and FINRA from 2018-20 fined dozens of Dual Registered RIA firms for excessive mutual fund fees around Share Class violations and Revenue Sharing in 401(k) and retail accounts. [vii]
· SEC – Merrill Lynch (Bank of America) – Share Class Violation April 17, 2020
· SEC- Wells Fargo (Bridgehaven) Share Class March 11, 2018
· SEC Morgan Stanley (Greystone) Share Class November 7, 2019
· SEC LPL 3/11/19 (Fiduciary First)
· FINRA AxaEquitable 19
· SEC MML Mass Mutual Sept 21 Rev Sharing Share class violations
· SEC VALIC Financial Advisors Inc. AIG-VALIC July 28, 2020 Rev Sharing Share class violations
· SEC VOYA Financial Advisors Inc ING-VOYA Dec. 21, 2020 Share class Rev Sharing Share class violations
· SEC PRUCO Securities, LLC Dec 23, 2020 Rev Sharing Share class violations
· FINRA PIMS (Prudential) June 2020
· SEC PRINCIPAL Securities, Inc. March 11, 2019 SEC Rev Sharing Share class violations
· SEC TRANSAMERICA Sept 30, 2020 fee gauging TA FINRA Share Class Variable 2020 annuities 2014 Fee Gauging
Any fiduciary who used these so-called consultants in the last 6 years has some serious fiduciary liability in a court case.
Any fiduciary who did not fire these so-called consultants after these SEC fines could have additional liability.
The following consultants have the ability to participate in conflicted activities like revenue sharing. Not every plan especially some of the largest ones, may have direct conflicts at a given point in time. This is especially true of Strategic Advisors a Fidelity affiliate as Fidelity has thousands of conflicted and non-conflicted plans.
LARGE CONFLICTED CONSULTANTS ie DUALlY REGISTERED
ADVISED ASSET GROUP LLC owned by Empower (formerly known as Great Western Strategic Advisors owned by Fidelity).
Plan Sponsors should look at the independence of their advisor/consultants and their regulatory record. Do they take ERISA fiduciary liability in their contracts?
If the consultant is lacking in fiduciary responsibility they should be fired. If these conflicts caused damage you should consider legal action.
[i]US Pension Investment Consultants A Report for Fiduciaries, Internal Audit and Risk Management Professionals in 2013[i] Diligence Review Corporation led by Jennifer Cooper, CF
I was in a local mall the other day looking for a dress shirt. I figured there would be no problem. Wrong. I had not been to a mall since the pandemic started. What I quickly discovered is that the work-at-home movement has resulted in less demand and, thus, less floor space for dress shirts. Makes sense. I had just not considered that as a possible result of the Covid pandemic.
But my trip to the mall made me think about the potential similarity, or changes, that we are already starting to see in the courts since the Northwestern decision. Actually, I think the trends we are seeing, and can expect to continue to see going forward, are a result of the combination of the Tribble, Northwestern and Brotherton decisions, what I refer to as the “fiduciary responsibility trinity.” (Trinity)
My recent post on the “CommonSense 401(k) Project” site, “The “Fiduciary Responsibility Trinity: ERISA Fiduciary Law After the Hughes/Northwestern Decision,” discussed the significance of each of the three decisions. In talking with colleagues in both the legal and 401(k)/403(b) consulting industry, they all report that plan sponsors seemingly have not responded to any of the legal issues addressed in the Trinity.
In talking with some plan sponsors, I have seen the same seeming “indifference” toward the changing legal landscape for 401(k)/403(b) plans and plan sponsors. I would describe the two attitudes that I have seen as “it is what it is, but we are not going to make it worse by tipping employees off to the situation, to “we’re just going to ignore it and hope we do not get sued.”
As I have explained to some plan sponsors, there are obvious risks to such strategies. ERISA attorneys routinely scan the Form 5500 records for possible cases. Plans that decide to ignore any ERISA problems and try to rely on the “we did not know, we meant no harm” defense can expect courts to reject such strategies citing that “willful ignorance” is no defense. Under ERISA, plan sponsors are held legally responsible for information that they knew, or should have known, by performing their legal obligation to independently perform a through and objective investigation and evaluation of all investment options within a plan.
What really amazes me is that so many plan sponsors are unwilling to even listen to objective suggestions from experienced professionals who could easily re-designed their 401(k)/403(b) plan to create a win-win situation for both plan sponsors and plan participants, one that truly furthers the “retirement readiness” campaign while reducing the costs of the plan and the potential liability exposure of the plan sponsor.
When I look at the current 401(K)/403(B) litigation crisis, I see one dominant theme- cost-inefficiency. When I say cost-efficiency, I mean both in terms of unnecessary fees/costs and in the overall design of most plans, especially with regard to the number of cost-inefficient investment options offered.
In Tibble, SCOTUS recognized the Restatement of Trusts (Restatement) as a viable resource in resolving fiduciary issues. The two dominant themes throughout the Restatement are diversification, as a means of risk management, and cost consciousness/cost-efficiency.
A couple of years ago I created a simple metric, the Active Management Value Ratio. (AMVR) The AMVR is based primarily on the concepts set out in Charles D. Ellis’ classic, “Winning the Loser’s Game.” I actually discovered Ellis’ classic in 1985, back when it was still titled “Investment Policy: Winning the Loser’s Game.” Ellis’ book forever changed the way I think about investing.
In creating the AMVR, I simply took Ellis’ core concept of comparing incremental costs to incremental returns.
So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!
That simple approach is reflected in the overall simplicity of the calculations required to compute an actively managed fund’s AMVR score. The following AMVR analysis charts show how the basic AMVR only requires the ability to subtract and divide.
In analyzing the AMVR data, the two key questions are:
1. Did the actively managed fund provide a positive incremental return? 2. If so, did the fund’s incremental return exceed the fund’s incremental costs?
If the answer to either of these questions is “no,” the actively managed fund is not cost-efficient, and an imprudent investment choice, relative to the benchmark fund.
The first AMVR analysis compares a fund often found in 401(k) plans, Fidelity Contrafund, K shares (FCNKX), with the Fidelity Large Cap Growth Fund (FSPGX). Since FCNKX failed to provide a positive incremental return relative to FSPGX, our fiduciary prudence analysis can stop.
The second AMVR analysis compares another fund commonly found in 401(k) plans, American Fund’s Growth Fund of America, R-6 shares (RGAGX), with the Vanguard Large Cap Growth Fund, Admiral shares. Again, since RGAGX failed to provide a positive incremental return relative to VIGAX, the fiduciary prudence analysis can stop.
Later, I revised the AMVR to allow investors, investment fiduciaries and attorneys to factor in the high correlation of returns that currently exists between most actively managed U.S. equity funds and comparable index funds. In my opinion, this allows for a more meaningful and valuable analysis of the cost-efficiency of an actively managed funds. After all, a plan sponsor’s fiduciary duties of loyalty and prudence require that the plan sponsor always put the plan participant’s and their beneficiaries’ interests first.
Many actively managed funds like to compare their returns to comparable market indices, such as the Standard & Poor’s 500 Index. Unlike comparable index funds, market indices do not have actual costs that can be used to evaluate cost-efficiency. Actively managed funds know this.
In my AMVR forensic analysis charts, I include a fund’s Active Expense Ratio, (AER) The AER metric, created by Professor Ross Miller, factors in an actively managed fund’s correlation of returns relative to a comparable index fund to produce the effective expense ratio of an actively managed fund.
Professor Miller explained the importance of and the concept behind the AER by stating that
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.
John Bogle also addressed the significance in factoring in correlations of return:
As active management continues to morph into passive indexing-already approaching the commonplace in the large-cap fund category-managers will have to reduce their fess commensurately. After all, a correlation of 99 comes close to meaning that 99 percent of the [the fund’s] portfolio is effectively indexed. A 1.5 percent expense ratio on the remaining portfolio, therefore, represents an annual fee of 150 percent(!) on the actively managed assets.
Even if investors are willing to tolerate that cost at the moment, it is only a matter of time until they realize that their ongoing deficit to the stock market’s return is a reflection of the simple fact that they effectively own an index fund, but at a cost that is grossly excessive.
The AMVR Fidelity Contrafund chart clearly shows how the combination of a high correlation of returns and high incremental cost can dramatically reduce an actively managed fund’s cost-efficiency
Another benefit of the AMVR is that it allows plan sponsors to avoid “closet index” funds. Closet index funds, aka “index huggers,” are actively managed mutual funds that promote the alleged advantages of active management in order to justify their high fees. However, in reality, such funds often track, in most cases actually underperform, comparable, but far less expensive, index funds. High incremental costs plus underperformance equal imprudence and fiduciary liability exposure.
Going Forward Bottom line, courts are increasingly realizing that there is simply no legally justifiable reason for plan sponsors not to make the changes required by the fiduciary responsibility Trinity, to properly protect both plan participants and themselves from unnecessary problems such as excessive fees and cost-inefficient investment options. Having an abundance of cost-inefficient investment options only provides proof of yet another form of cost-inefficiency, the law of diminishing returns.
Creating a win-win 401(k)/403(b) plan is relatively simple. But plan sponsors must be willing to at least listen to sound, simple, and objective advice from experienced 401(k) consultants and learn how to properly utilize analytical tools such as the Active Management Value Ratio, as the legal field is increasingly using the metric to establish liability and calculate damages.
The changes created by the fiduciary responsibility Trinity are not going anywhere, Therefore, it is incumbent on plan sponsors to make the necessary changes, both in terms of attitude and design, or face litigation, even repeated litigation, for their failure to fulfill their fiduciary duties. As Einstein properly noted, “[w]e cannot solve our problems with the same thinking we used when we created them.”
James W. Watkins, III, is a licensed attorney (41 years), specializing in securities and ERISA law, a Certified Financial Planner™ professional (32 years) and an Accredited Wealth Management Advisor.™ He has extensive experience in evaluating the legal prudence of various types of investments, including mutual funds, and advising 401(k)/403(b) pension plans on both designing and monitoring plans to ensure legal compliance.