Brave New World: How Hughes v. Northwestern, the “Fiduciary Responsibility Trinity,” and the Active Management Value Ratio Are Changing the 401(k) Landscape

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.  

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