SCOTUS 9-0 ERISA decision – confirms my view on Annuities as Prohibited Transactions
By Chris Tobe, CFA, CAIA
The Supreme Court ruled unanimously in favor of 401(k) Transparency, while also placing the burden of proof on plan sponsors alleging that they are protected under an exception to the Prohibited Transaction rules. This rule facilitates forcing disclosures on conflicts of interest and hidden fees.[i] Investments that the managers have the potential for a conflict of interest are labeled “Parties of Interest” in the DOL/IRS 5500 forms attached financials for ERISA plans. These parties in interest have the burden of proof that they have an exemption from the Prohibited Transactions rules.
Fixed Annuities, known as IPG’s, are prevalent in large ERISA DC plans. The largest IPG is TIAA Retirement Choice Annuity which is central in the Cornell plan and, along with Fidelity, the focus of the SCOTUS decision.
I believe that all annuities are prohibited transactions due to the inherent conflict of interest issues, and in most cases, the annuity issuer and annuity salesperson are labeled in plans as parties in interest. Prohibited transaction exemptions are subject to meeting certain requirements. But the DOL does not even attempt to enforce them. Many plans just blindly accept the claims of annuity salesmen that these contracts have a “get out of jail free card” in the form of a PTE.
Prohibited Transactions Exemption PTE 84-24
Annuities for decades have claimed Prohibited transaction exemptions behind PTE 84-24. However, plans are responsible for verifying that the prohibited transaction exemptions apply to the insurance products they put in their plans. This SCOTUS decision and future similar cases may force accountability for the first time.
ERISA PTE 84-24, which is based on the Restatement of Trust, states the annuities must meet the following requirements called the Impartial Conduct Standards and Written Disclosures and Policies and Procedures backing up these standards. Most annuities I have seen do not even come close.
The Impartial Conduct Standards have 4 major obligations. A. Care Obligation B. Loyalty Obligation C. Reasonable compensation limitation D. No materially misleading statements (including by omission)
Care Obligation This obligation reflects the care, skill, prudence, and diligence – similar to Prudent Person Fiduciary standard. Diversification is one of the most basic fiduciary duties. Fixed annuities flunk this with single entity credit and liquidity risk. Diligence is nearly impossible with misleading, nontransparent contracts, and the lack of plan/participant ownership of securities.[ii] The Federal Reserve in 1992 exposed the weak state regulatory and reserve claims.[iii]
Loyalty Obligation Annuity contracts are designed to avoid all fiduciary obligation with no loyalty to participants. Secret kickbacks and commissions place the financial interests of the Insurers and their affiliates over those of retirement investors. In most cases, the annuity investor has little chance of even breaking even on the investment. The exemption requires the advisor to show their loyalty with a “Fiduciary Acknowledgement Disclosure.” Annuity contracts avoid any fiduciary language or responsibility.
Reasonable compensation limitation Annuities have a total lack of disclosure of profits, fees and compensation – effectively denying any chance for a prospective purchaser to make an “informed decision.” They also have secret kickback commissions.[iv] A number of lawsuits have settled with claims of excessive secret fees and spreads. An insurance executive bragged at a conference of fees over 200 basis points (2%) in 2013. [v]
No materially misleading statements (including by omission) Annuities have numerous material misleading statements, including the total lack of disclosure of spread/fees. They claim principal protection, but some fixed annuity contracts recently have “broken the buck” and violated their contracts. The written disclosures under weak state regulations omit critical information on risks and fees also prevents any opportunity for an “informed decision.”
GOING FORWARD
While Annuities are by far the largest area involved, I believe SCOTUS’ Cunningham decision will result in some significant consequwemces:
ERISA class action 401k litigation will explode especially against conflicted products like annuities[vi]
Plans are now talking about taking legal action against vendors, who tricked them into these non-transparent products[vii]
Plans will be more reluctant to take on non-transparent products like annuities[viii]
Plans will be more reluctant to take on non-transparent products like crypto and private equity[ix]
Plans will be more reluctant to do non-transparent administrative practices like revenue sharing[x]
Plan Sponsors with fixed annuity contracts should demand : 1. A MFN clause to make sure they have the best rate. A MNF (Most Favored Nation) clause is a clause that states that money managers are getting the lowest fee for their pension clients. 2. A downgrade lause that allows liquidity at full book value if the insurance company issuing the annuity is downgraded.
Annuities are clearly prohibited transactions that do not qualify for an exemption but have used their lobbying power in Washington and in states, to exempt themselves from all accountability. This recent SCOTUS decision may help get accountability and transparency in plans through litigation.
“Cerulli Edge—U.S. Retirement Edition,” finds that as of 2024, 91% of asset managers believe guaranteed lifetime income options carry a negative stigma. “Annuities continue to face perception issues due to high fees, complexity, lack of transparency, and concerns about insurer solvency, all of which deter plan participants,” says Idin Eftekhari, a senior analyst at Cerulli. “The tradeoff between liquidity and a guaranteed income stream is unappealing for many participants.[iii]
The argument that you need annuities to provide lifetime income is debunked as well.
Cerulli also points to lower cost transparent liquid methods of providing monthly income called “structured drawdown strategies” as superior alternatives to annuities.[iv]
Annuities are a Fiduciary Breach
I wrote in 2022 that all annuities are a fiduciary breach [v] While Guaranteed Income Annuities are still small in 401(k)s, I believe they are being used to justify even worse annuity products like IPG Fixed Annuities and Index annuities. Immediate Participation Guarantee (IPG) is a Group fixed annuity contract (GAC) written to a group of investors in a DC Plan and not individuals. [v]
IPG group annuities have no maturity, and set whatever rate they want without a set formula.
Annuities are contracts that are an ERISA Prohibited Transaction. Annuity providers claim their products are subject to Prohibited Transaction Exemption 84-4, but I have found that most annuities I have seen do not qualify for the exemption.[vi]
Annuity contracts are regulated by weak state insurance commissioners, and most plan sponsors are clueless to that fact. The National Association of Insurance Commissioners (NAIC) sets weak national standards, but some state insurance commissioners have even weaker regulations. NAIC’s prime goal is to prevent any national regulation or transparency as evidenced in this letter to Congress. [vii] NAIC is currently trying to hide insurers Risk Based Capital (RBC) scores to hide significant risk from consumers. [viii]
There is an attempt to hide annuities in Target Date Funds in weak state regulated CIT’s in which I testified on to the DOL Advisory Committee in July 2024.[ix]
Annuity contracts shift all the fiduciary burden from themselves to the plan. Thus, the burden of proof is on plan sponsors regarding if their plan annuity qualifies for an exemption from being classified as a prohibited transaction.[x]
Annuities Credit & Liquidity Risk High & Getting Higher
A recent Federal Reserve paper exposes poor state & offshore regulation of Life Insurance companies that issue Annuities. The FED’s main problem is the hiding and understating of credit, liquidity & leverage risks.[xi]
The FED economists contend that life and annuity issuers make investments in what amount to loans to risky firms look stronger by funneling the weak loans through arrangements — such as business development companies, broadly syndicated loan pools, collateralized loan obligations, middle-market CLOs and joint venture loan funds — that qualify for higher credit ratings.[xii]“These arrangements seek to shift portfolio allocations towards risky corporate debt while exploiting loopholes stemming from rating agency methodologies and accounting standards.”[xiii]
Insurance risk experts Larry Rybka, Thomas Gober, Dick Weber Michelle Gordon highlight the addition of risks from Reinsurance in a recent trade publication. Rybka says The life insurance and annuities industry, he said, has become “like the Wild West.” Carriers are abusing reinsurance,”[xiv] “It’s a shell game and, in general, the regulators are not paying attention,” said Dick Weber,[xv]Gober says It’s not just offshore reinsurers that can largely skirt U.S. accounting standards, he said. There are also “captive” reinsurance companies within the U.S. mostly in Vermont, South Carolina, and Delaware. “The lack of transparency with these affiliated reinsurance companies, both captive and offshore, is the single biggest threat to U.S. policyholders and annuitants,” said Gober.[xvi]
Michelle Gordon says that advisors should check the creditworthiness of any insurance companies they recommend to clients, she said, though most don’t or can’t because of lax ratings standards. “The non-codification of insurance advisement results in sub-optimization of consumer protections,” she said.[xvii]
Fiduciaries should be aware of these risks and have a duty to defend and justify these risks if they put annuities in their plans.
Economic and Policy Research’s Eileen Appelbaum said “Much as private equity firms may wish it were different, they have been mostly unable to worm their way into workers’ 401(k)s and abscond with their retirement savings,”[i]
The Private Equity industry’s limited success and future success depends on Private Equity and related contracts like Private Debt finding tricks that block transparency to hide their excessive fees and risks, and inferior performance in ERISA plans.
The first trick is to exempt the actual Private Equity contact itself exempt from ERISA by a loophole of commingling it with non-ERISA public pensions and other non-ERISA plans.
In the context of a Private Equity contract, a “20% ERISA exemption” generally refers to a situation where a fund is considered exempt from full ERISA regulations if less than 20% of its total investor base consists of “benefit plan investors” (like retirement plans), meaning that the fund doesn’t need to adhere to the stricter rules of ERISA as long as the percentage of ERISA-regulated money invested remains below 20% of the total fund size.[ii]
The second trick is to domicile the Private Equity contract in a place with lax laws. Roughly a third of the private equity contracts are domiciled in the Cayman Islands and much of the rest in the State of Delaware.[iii]
The third trick is one I warned the DOL ERISA Advisory council in July 2024. I focused on the hiding of Private Equity and other illiquid contracts buried in Target Date Funds.[iv] SEC registered Mutual funds require too much transparency on fees and risks so Private Equity has avoided them. Federal OCC regulated Collective Investment Trusts (CIT’s) also require too much transparency. Instead, the Private Equity Industry needs a weak regulator that requires minimum transparency, and they have found it by cherry picking the laxest of 50 state banking regulators. In May 2023, SEC chair Gary Gensler sounded the alarms on CIT’s “Rules for these funds lack limits on illiquid investments and minimum levels of liquid assets. There is no limit on leverage, or requirement for regular reporting on holdings to investors”[v]
Private Equity DOL Guidance
DOL guidance seems to shift with the political winds. Around 4 years ago Forbes Columnist Ted Siedle wrote “Trump DOL throws 401k Investors to the Wolves” [vi] At Berkshire Hathaway annual meeting (2019) Buffett stated, “We have seen a number of proposals from private equity firms where the returns are not calculated in a manner that I would regard as honest… If I were running a pension fund, I would be very careful about what was being offered to me.” Other publications warned of Leading U.S. Retirees ‘Lik Lambs to the Slaughter’[vii]
This was due to the trade press and Private Equity industry interpreting a June 2020 DOL letter as a “get out of jail free card” for plan sponsors to load up on Private Equity if it is buried in Target Date Funds. What the letter says is that theoretically the perfect Private Equity fund with a high level of transparency and independent verifiable valuation could be included in a diversified Target Date Fund.
I do not thing this perfect Private Equity contract investment exists, and the burden of proof is on the plan sponsor to prove that it does exist when they went into the contract and to continually monitor the contract to make sure it stays “perfect”. [viii]
Morningstar asks Can the presence of a largely illiquid fund comply with DC ERISA regulation? An answer arrived in a June 2020 “Information Letter” in which the Department of Labor addressed a proposal by Pantheon Ventures LP, and Partners Group, Inc. to put private equity within a target-date fund. The DOL letter states that this would not violate ERISA provided the vehicle resided within a diversified managed solution like a target-date fund or managed account, and that it was otherwise walled off to participants. Additionally, the fund within which the illiquid investment resides must have a “sufficient” level of liquidity—that is, investment in public-market vehicles to meet likely participant demands. These are guidelines rather than specific rules, but they appear sufficiently actionable for a competent fiduciary.[ix]
But if you look at the actual information letter, you can see this part was cherry picked to spin a positive story for sneaking in Private Equity 401(k).[x] The DOL in full, warns plan sponsors of numerous potential fiduciary issues. Statements like plan fiduciaries have duties to prudently select and monitor any designated investment alternative under the plan, and liability for losses resulting from a failure to satisfy those duties.[xi] In evaluating … fiduciary must engage in an objective, thorough, and analytical process[xii] Warns of typically, higher fees and that you must evaluate the risks and benefits returns net of fees including management fees, performance compensation, or other fees or costs that would impact the returns received)…, including cost, complexity, disclosures, and liquidity, and has adopted features related to liquidity and valuation designed to permit the asset allocation fund to provide liquidity for participants [xiii] Ensure that private equity investments be independently valued according to agreed-upon valuation procedures. [xiv] DOL also shows a duty to monitor “The fiduciary also must periodically review whether the investment vehicle continues to be prudent[xv] DOL also talks about the requirement to be fully transparent to participants whether plan participants will be furnished adequate information regarding the character and risks of the investment alternative to enable them to make an informed assessment [xvi] Especially noted a higher level of fiduciary duty for a qualified default investment alternative (QDIA) [xvii]
The DOL clarified these requirements early in the Biden Administration in late 2021. [xviii] “Cautions plan fiduciaries against the perception that private equity is generally appropriate as a component of a designated investment alternative in a typical 401(k) plan. [xix] The DOL letter did not endorse or recommend PE investments.[xx]
During the Trump administration, Private Equity is expecting a friendlier DOL on messaging. The DOL has never really engaged in any broad investment enforcement, and I expect we will see more of the same during the Trump administration.
Private Equity Does not meet exemptions standards for being a Prohibited Transaction.
Plan sponsors do not need to fear the DOL, but they do need to fear litigation if they invest in Private Equity. Looking at all the ERISA attributes that Private Equity needs to be exempted from Prohibited Transactions – Private Equity flunks all the impartial conduct standards in numerous ways.
Private equity offering documents generally prominently state (in capital, bold letters) that an investment in a private equity fund is speculative, involves a high degree of risk, and is suitable only for persons who are willing and able to assume the risk of losing their entire investment. Most contracts that PE can engage in borrowing, or leverage, on a moderate or unlimited basis. There is no assurance of diversification since funds generally reserve the right to invest 100 percent of their assets in one investment. There are also heightened legal, regulatory, operational and custody risk. [xxi]
Private Equity has a myriad of conflicts of interest, self-dealing practices. The investment manager determines the value of the securities held by the fund. Such a valuation affects both reported fund performance as well as the calculation of the management fee and any performance fee payable to the manager. [xxii]
Private Equity has business practices that violate ERISA in many ways. Private equity fund offering documents often disclose that investors agree to permit managers to withhold complete and timely disclosure of material information regarding assets in their funds. Further, the fund may have agreed to permit the investment manager to retain absolute discretion to provide certain mystery investors with greater information and the managers are not required to disclose such arrangements. As a result, the fund you invest in is at risk that other unknown investors are profiting at its expense—stealing from you. [xxiii]
A Private Equity-like structure technically private debt has cost JP Morgan over $400 million in damages in 401(k) litigation. This private debt was put in a state regulated JP Morgan CIT, which was put in JPM broad bond CIT, with was put in a JPM stable value CIT.[xxiv]
Plan sponsors will have a tough time justifying Private Equity as being exempted as a prohibited transaction given these facts.
Private Equity Performance and Valuation Issues
With such a lack of controls over the contracts, reliable valuation and performance in Private Equity is almost impossible and benchmarks are mostly useless.[xxv]
The entire justification Fiduciaries must rely on is the superior performance of Private Equity which has been proven to be mostly false after excessive fees.[xxvi] A report by University of Oxford professor Ludovic Phalippou shows that in the last 15 years, private equity firms generally have not provided better returns to investors than low-fee stock index funds. Prof. Phalippou has shown excess mostly hidden fees and expenses to exceed 6% killing net returns.[xxvii]
Noted founder of investment consulting firm Richard Ennis in quoting Beath & Flynn 2020 study says that private equity (as a class of investment) in fact ceased to be a source of value-added more than a decade ago. [xxviii] Jeff Hooke of Johns Hopkins book the “Myth of Private Equity” goes into detail on the asset class and its numerous fiduciary flaws. He documents that many performance claims are made up by the managers with no independent verification and are greatly exaggerated. [xxix] Academic Wayne Lim finds Fees and Expenses totaling over 6-8% The corresponding fee drag on gross-to-net total value to paid-in capital is 0.1x to 0.7x and 5% to 8% in annualized terms. [xxx]
Conclusion
Private Equity along with other illiquid contract investments are a potential Fiduciary Time Bomb for plans and their participants. Does the fiduciary even know if the Private Equity contract is subject to ERISA or exempt. Is the contract domiciled in the Cayman Islands? If its buried in a target date fund, is it in a mutual fund, or a poorly regulated state CIT?
A lack of transparency makes it impossible for fiduciaries to prove that Private Equity contracts are worthy of a Prohibited Transaction exemption. Worse, most have excessive fees and risks which cause real damages to participants. While the Private Equity industry may be able to prevent regulation, the real threat of litigation will lead to prudent fiduciaries keeping Private Equity out of ERISA plans.
[xiv] that satisfy the Financial Accounting Standards Board Accounting Standards Codification (ASC) 820, “Fair Value Measurements and Disclosures,”9 and require additional disclosures needed to meet the plan’s ERISA obligations to report information about the current value of the plan’s investments.
[xvii] for the plan under 29 CFR 2550.404c-5. Moreover, as noted above, the fiduciary responsible for including the fund on the plan’s investment menu always retains responsibility for ensuring that the decision to retain the fund is consistent with the fiduciary responsibility provisions of Section 404 of ERISA.
Pension Risk Transfer Annuities (PRT’s) replace a solid diversified defined benefit plan with federal (PBGC) insurance, with a high single entity risk annuity with higher risks and weak state regulation.
Pension Risk Transfers (PRT’s) shift the risk off the plan sponsor onto the backs of the participants. This allows plan sponsors to lower costs and insurance companies billions at the expense of participants and retirees.
It appears that large pension plans have been in a hurry to close Pension Risk Transfer deals, before their victims the participants wake up and see the raw deal they are getting.[i] Regulators, to my knowledge, have never tested this risk with actuarial analysis. Under industry pressure they came up after the Executive Life defaults IB95-1 a weak rule to pick the “safest available annuity”. I think the premise of a least risky annuity would is like a less risky plane crash.
However, plan sponsors are not off the hook, due to the ability of plaintiffs to recover these losses through litigation. The Burden of proof is on plan sponsors that their plan PRT Annuity contract has low enough risk to be exempted from being a Prohibited Transaction and is at a reasonable cost.
Fiduciary Breaches of PRT Annuity Contracts
PRT Annuity Contracts are a Fiduciary Breach for 4 basic reasons.[ii]
Structure -weak cherry-picked state regulated contracts, not securities and useless reserves [vi]
These breaches make it impossible for most annuity products to qualify for exemptions to Prohibited Transactions.[vii]
The Federal Reserve in 1992 exposed the weak state regulatory and reserve claims of Fixed annuities in retirement plans.[viii] In 2008 Federal Reserve Chairman Ben Bernanke said about these annuity products “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.”[ix] In the major stable value annuity source book, single annuity like PRTs are shown to have 10 times the risk of a diversified fixed portfolio. [x]
.
The Burden of proof is on plan sponsors that they have documented due diligence on these risk issues and that their PRT Annuity contract is exempted from being a Prohibited Transactions. [xi]
As a plan sponsor you should put all products through these fiduciary transparency tests, I contend that annuities almost always flunk this basic level of care.
Annuities avoid transparency with poor state regulated structures which allow them to hide excessive risks and fees. Annuity providers fight hard to avoid any Federal Regulations usually favoring state regulation in their home states where they are major employers and have higher political influence. Even industry insiders admit hidden fees are problematic to adopting annuities.[xii]
After the 2008 financial crisis several Insurers were forced into Federal Regulation under SIFI (too big to fail) they did everything to get out of the higher transparency and higher capital requirements.[xiii]
Annuity contracts have been characterized by retirement group NAGDCA as having serious fiduciary issues. “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.
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 “[xiv]
Plans need to put their Loyalty to plan participants first which is their fiduciary duty. They do not have loyalty to vendors such as money managers and annuity providers.
Annuities have an Inherent conflict because investment dollars leave the ownership of the plan and participants and become part of the balance sheet of the insurance company.
Annuity contracts are designed to avoid all fiduciary obligation with no loyalty to participants. Most annuity providers refuse to sign a “Fiduciary Acknowledgement Disclosure.”
DOL official Khawar said. “” Under the National Association of Insurance Commissioners’ model rule, for example, “compensation is not considered a conflict of interest,”[xv]
Annuities have a total lack of disclosure of profits, fees and compensation. They have secret kickback commissions. How can a plan claim any of the compensation annuity provider receives is reasonable if it is secret and not disclosed.
Current Cases – Worst of Worst Athene-Apollo
PRTs have been operating under a weak DOL rule to pick the “safest available annuity”. Over decades traditional insurers have made millions. While default risk is present with traditional insurers, they do want to sustain the business long-term and avoid default. When Private Equity players got involved, with their short-term mentality, they are set to strip billions in profits, not afraid to bankrupt companies and “kill the Golden Goose” for the traditional part of the business.
With these significant differences in risks and profit for the private equity insurers, it has created measurable damages that has jump started litigation.
From Piercy v. AT&T filed on 3/11/24 says, AT&T turned its back on its retired workers, choosing to put the pensions of almost 100,000 AT&T retirees in peril, to secure AT&T an enormous profit. AT&T stood to gain—and did gain—more than $360 million in profit from this scheme The only losers in the transaction were AT&T’s retirees, who face the danger—now and in the future—that their lifelong pensions will go unpaid while they have lost all the protections of federal law.
As pointed out above the standard PRT is at least 10 times that of a diversified portfolio, but that an even riskier single entity credit risk like private equity backed Athene could have 20 times the risk. [xvi]
Most of the current PRT cases are against Apollo owned Athene. Apollo is infamous with over
684 regulatory violations. [xvii] Fines range from the DOJ $210 million fine for accounting fraud, to $53 Million by the SEC for misleading investors on fees. [xviii] Other claims against Apollo are around investor protection violations, consumer protection violations, and the false claims act.
In early 2021 Apollo founder & CEO Leon Black resigned after paying $158 million in “tax advice” to Jeffrey Epstein.[xix] In 2015 Apollo was involved in a massive pay to play scheme involving a trustee and CEO of CALPERS the US largest public pension. The CALPERS CEO Buenrostro was sent to prison and the trustee Villalobos committed suicide before serving his term.[xx]
Conclusion
In a submitted academic paper on Annuity risks it touts the risks of PRT’s. It states the “Emperor has no Clothes” as the life insurance industry has poured billions of dollars into advertising, lobbying, commissions & trade articles with misinformation on annuities with everyone afraid to call out the obvious.[xxi]
The ultimate responsibility and the burden of proof goes on to the plan sponsor to prove this annuity purchase was for the benefit of participants. Those who have pulled the trigger on these questionable annuity deals will probably face litigation.
[xxi] Lambert, Thomas E. and Tobe, Christopher B., “Safe” Annuity Retirement Products and a Possible US Retirement Crisis (March 18, 2024). Available at SSRN: https://ssrn.com/abstract=4763269
Annuities should not be allowed in 401(k)s. ERISA created the concept of Prohibited Transactions to prohibit any investments with clear Conflicts of Interest. I testified to the ERISA Advisory Council – US Department of Labor in July of 2024 on the danger of allowing annuities to be hidden inside of Target Date Funds. [i] I have co-written a paper with Economics Professor Tom Lambert on the excessive risks of annuities.[ii]
Perhaps with the exception of Crypto and Private Equity no investment better describes what should be a prohibited transaction more than annuity contracts.
Annuities are a Fiduciary Breach for 4 basic reasons.[iii]
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
So why do we still see annuities in 401k plans? The reason is intense lobbying by the insurance industry, that has blocked any transparency or oversight.
Annuity providers claim to be barely legal by relying on an Prohibited Transaction Exemption (PTE 84-4) a “get out of jail free card” obtained by $millions of lobbying by the insurance industry.
Biden Fiduciary Rule
The new Biden Fiduciary rule would provide transparency that would further expose these annuity products’ conflicts of interests. The insurance industry has forue shopped in Texas in the Fifth Circuit for judges who agree with blocking transparency to block it for now.
At the Certified Financial Planner Board of Standards Connections Conference in Washington October 2024, DOL officials called out annuities as prohibited transactions. [iv] Ali Khawar, principal deputy assistant secretary for the Employee Benefits Security Administration, laid out the reasons why the Biden Labor Department continues to fight for a fiduciary rule ““To me it continues to be kind of nonsensical that you’re expecting any of your clients to walk into someone’s office and have in their head: ‘I’m dealing with this person who’s going to sell insurance to me, this person is relying on [Prohibited Transaction Exemption] PTE 84-24, not [PTE] 2020-02. Those things shouldn’t mean anything to the average American. And we shouldn’t expect them to.”
broker-dealer space transformed what it means to be in the advice market,” Khawar said. “When we looked at the insurance market, though, we didn’t quite see the same thing.”
Under the National Association of Insurance Commissioners’ model rule, for example, “compensation is not considered a conflict of interest,” Khawar said. “So there are pretty stark differences between what you see in the CFP standard, the Reg BI standard, and what has now been adopted by almost every state, one notable exception of New York, which has adopted a standard that is significantly tougher than the NAIC model rule.”[v]That process is “the CFP standard, the DOL standard, it’s the SEC standard for investment advisors and it’s Reg BI,” Reish continued. What it’s not? “The NAIC model rule,” Reish said.
“The NAIC model rule does not require the comparative analysis[vi]
Khawar added: “It’s not going to matter whether you’re providing advice about an annuity, a variable annuity, fixed income annuity, indexed annuity, security or not.” The goal with the 2024 rule, Khawar added, is to “have a common standard across the retirement landscape so that all retirement investors would be able to make sure that when someone is marketing up front best-interest advice, that that’s the standard they’d be held to by the regulator and the customer.”
Under the Employee Retirement Income Security Act, “being a fiduciary is critical to the central question of whether or not the law or consumer protections have fully kicked in or not,” Khawar added.
The Government Accounting Office wrote a piece in August in support of the Biden Fiduciary rule. They saw the problem as so severe that they suggested that IRS step in to help the DOL Better Oversee Conflicts of Interest Between Fiduciaries and Investors especially in the Insurance Annuity Area. [vii] Senator Elizabeth Warren in defense of the Biden Fiduciary rule prepared a report on the numerous conflicts of interest in annuity commissions and kickbacks. [viii]
Annuities days of hiding behind PTE 84-4 are over
Prohibited transaction exemptions are subject to meeting certain requirements. They include
The Impartial Conduct Standards.
Written Disclosures.
Policies and Procedures
Annual Retrospective Review and Report
The Impartial Conduct Standards have 4 major obligations.
A. Care Obligation
B. Loyalty Obligation
C. Reasonable compensation limitation
D. No materially misleading statements (including by omission)
Care Obligation
This obligation reflects the care, skill, prudence, and diligence – similar to Prudent Person Fiduciary standard. Diversification is one of the most basic fiduciary duties. Fixed annuities flunk this with single entity credit and liquidity risk. Diligence is nearly impossible with misleading nontransparent contracts, and the lack of plan/participant ownership of securities. The Federal Reserve in 1992 exposed the weak state regulatory and reserve claims.[ix]
Loyalty Obligation
Annuity contracts are designed to avoid all fiduciary obligation with no loyalty to participants. Secret kickback and commissions place the financial interests of the Insurers and their affiliates over those of retirement investors.[x]
The exemption requires the advisor to show their loyalty with a “Fiduciary Acknowledgement Disclosure.” Annuity contracts avoid any fiduciary language or responsibility.
Reasonable compensation limitation
Annuities have a total lack of disclosure of profits, fees and compensation. They have secret kickback commissions.
A number of lawsuits have settled with claims of excessive secret fees and spreads. An Insurance executive bragged at a conference of fees over 200 basis points (2%) in 2013. [xi]
No materially misleading statements (including by omission)
Annuities have numerous material misleading statements, including the total lack of disclosure of spread/fees. They claim principal protection, but some fixed annuity contracts recently have broken the buck and violated their contracts. The written disclosures under weak state regulations omit critical information on risks and fees.
Most plans with annuities do not have Investment policy statements, since most fixed annuities would flunk them on diversity and transparency and not be allowed. Annuities cannot provide the transparency to follow CFA Institute Global Performance Standards (GIPS) so they do not comply.[xii] Most 401(k) committees with insurance products do not review such annuity products, since they clueless on what they are. Consultants for plans with annuities do not review the annuities most of the time since they are conflicted and they themselves receive kickbacks from annuity providers.
Annuities as a Prohibited Transaction
Annuities hide most of their compensation. They are typically secret no bid contracts with no transparency and numerous conflicts of interest. They are subject to weak state regulations (sometimes categorized as NAIC guidelines). Many times they are a party of interest and shift profits from annuities to make other fees appear smaller.
Annuities are clearly prohibited transactions, but have used their lobbying power in Washington and in states to exempt themselves from all accountability.
Testimony to ERISA Advisory Council – US Department of Labor by Chris Tobe, CFA, CAIA July 10, 2024
I want to concentrate on the largest QDIA – Target Date Funds. Target Date Funds (TDF’s) are now above 50% of all 401(k) assets. They deserve more fiduciary oversight by regulatory structure and internal policy – not less. Historically Target Date Funds in SEC registered mutual funds have been a solid norm. The industry wants to insert high fee high risk non-transparent contracts like Annuities, Private Equity and Crypto into Target Date funds, but SEC registered mutual funds transparency requirements prevent them, so they seek to open up other structures particularly Collective Investment Trusts (CITs).
Target Date Funds are the dominant default option or QDIA (Qualified Default Investment Alternatives) in most plans resulting in the highest level of fiduciary responsibility. They are the most non-transparent plan investment option and the easiest to hide fees and play performance games. Despite the high level of fiduciary risk, TDF’s are specifically designed to avoid accountability and thus need the most scrutiny.[1]
QDIA History
I have been involved in the QDIA issue for over 17 years when I wrote and signed the 2006 QDIA letter for AEGON Institutional Markets In late September 2023 I, along with former Assistant Labor Secretary Phyllis Borzi, briefed the White House Office of Management and Budget (OMB) and the Department of Labor on the proposedFiduciary Rule now out but under legal attack. I emphasized the severe fiduciary issues that surround contract products like annuities and private equity. I urged the need for strong fiduciary standards especially as annuities and private equity are being put in Target Date funds which are QDIA’s which need the highest level of transparency and accountability.[1]
Federally Regulated Structures
I believe the highest levels of transparency and accountability are in federally regulated investment structures with underlying federally regulated securities. No matter the structure plans and participants need transparency down to the underlying SEC registered stocks and bonds. Not a dead end to a piece of paper or a contract with no federal protections.
SEC registered mutual funds, while not perfect, are a fairly transparent structure that in general provides the accountability needed for the QDIA. The fiduciary analysis that James Watkins did earlier depends on the transparency of SEC Mutual Funds. Once we get away from Federally regulated mutual funds the issues with transparency and accountability multiply
I think the DOL to properly regulate needs a partner federal regulator in investments– i.e. the SEC on mutual funds, with CIT’s perhaps the OCC to ensure protection of retirement assets.
Target Date CITS
Collective Investment Trusts or CITS have grown by $ billions especially as Target Date Funds in the QDIA role.
There is a general assumption that CITs are regulated by the Federal Government Office of Comptroller of the Currency. Some CITs are regulated by the OCC while most used in 401(k)s are regulated by one of 50 state bank regulators. This allows CITs to choose their own state regulator who may or may not have lax oversight. [1]
Some CITs have full transparency down to the security level and are clones of established mutual funds such as Vanguard and Fidelity and are actually superior because of lower fees to the mutual funds, but many do not. In May 2023, SEC chair Gary Gensler sounded the alarms on CIT’s “Rules for these funds lack limits on illiquid investments and minimum levels of liquid assets. There is no limit on leverage, requirement for regular reporting on holdings to investors…”.[1]With these lax rules they can hide high fees and high risks in non-securities, contracts such as private equity, crypto and annuities.[2]
Accumulation 99% – Decumulation1%
Small 401k balances are the biggest threat to retirement security. The median balance reported by Fidelity in May was only $28,900[3] Fees are a major drag on balances over time.
For Decumulation just make withdrawals on a calculator without the added fees and risks of an annuity there is already a low-cost solution. Many 401k plans on web site give you a withdrawal amount for a certain number of years. The Decumulation issue is primarily a sales push by the annuity industry
On Longevity Risk I am more concerned with participants outliving their weak state regulated insurance company than outliving their income. Risk and high fees on annuities create more problems than they solve.
Annuities are sold not bought. I spent 7 years in institutional annuity product design with AEGON/Transamerica.I believe if participants were ever given full disclosures on inflation adjusted income, fees and risks in annuities they would never choose them themselves. According to the Federal Reserve[1] and my latest submitted paper[2] annuity risks are excessive.
Starting only in the last month the trade press has started saying the quiet part out loud mentioning the fact spread/fees are not disclosed could be problematic for putting annuities into target date funds.[3] These spread/fees have been some of the best kept secrets in investments slipping out last in 2013 when an executive bragged at a conference, they were over 200 basis points. [4] Under any fiduciary analysis annuities should be prohibited transactions and are only allowed under an exemption.[5]
The annuity industry is trying to get the DOL to aid them tricking or forcing their products onto participants. This requires the use of cherry-picked state insurance regulators for the insurance contracts and the use of cherry-picked state banking regulators to hide these products in poorly state regulated CIT’s. [6]
Participant support you see in industry polls is driven by the perception of an annuity as close to the size of a social security payment. The average person has 12 different jobs, and with the median balance would produce an annuity of maybe $250 a month. [7] Since Social security is indexed to inflation, and annuities are not, most will be immaterial in $$ to social security (5% to 10%). Participants, when given a choice and full transparency, will for the most part avoid annuities.
I am perplexed why the DOL would help in blocking transparency to participants
Mutual funds are not perfect
While they are the most transparent vehicle currently, Target Date Mutual Funds are not without issues. Changes and differences in Asset Allocation are not easy to follow and understand by participants. James Watkins calls it the Black Box issue around changing asset allocations. Here is what I said in my Pensions & Investments piece in May.
Yet even in an SEC regulated mutual fund, performance can be manipulated more easily in Target Date Funds. For example, a 2040 fund could have a 90% Equity/10% Fixed allocation with high fees and outperform in most time periods a 2040 fund with a 80% Equity and 20% fixed allocation with low fees. Performance manipulation games are even easier in a state regulated CIT. If the performance is not broken down by asset class and risk adjusted for asset allocation it is useless to a fiduciary.[14]
QDIA Recommendations
QDIA investments should be held to the highest fiduciary standards of transparency and accountability.
I would never recommend a state regulated annuity product because of the excessive hidden fees and risks for any part of a 401k plan. I would never recommend Private Equity or other non-regulated contract for any part of a 401k plan. I would never recommend Crypto or related non-regulated products to any part of a 401(k) plan.
Blessing any of these products for the QDIA creates many risks in the future
SEC registered Mutual Funds are OK for now, but outside them structures should have 100% underlying plan/participant ownership in SEC registered securities – stocks and bonds. This can be tested by using investments which can and are willing to adhere to CFA Institute Global Investment Performance Standards (GIPS) [2].
Collective Investment Trusts (CIT’s) should be Federally regulated by the Office of Comptroller of Currency (OCC), not by the weakest of 50 cherry picked state banking regulators.
The DOL should be pushing for more transparency, not allowing less.
BIO
Chris Tobe, CFA, CAIA has over 20 years’ experience working with 401(k) investments as a consultant and currently is the Chief Investment Officer for Hackett Robertson Tobe. His opinions do not necessarily reflect those of HRT. He works directly as a consultant to retirement plans and serves as a litigation consultant on many ERISA cases. He writes a column for the Commonsense 401K Project and has an upcoming book 401k Investments- Target Date and Stable Value
Liability-driven investing is a common concept in connection with defined benefit plans. I first heard the term used in a article by Marcia Wagner of the Wagner Group. Liability-driven investing refers to the selection of investments that are best designed to help the plan secure the returns needed by the plan to fulfill their obligations under the terms of the plan.
It has always struck me that the liability-driven concept is equally applicable to designing defined contribution plans such as 401(k) and 403(b) plans. Better yet, by factoring in fiduciary risk management principles, defined contribution plans can create the best of both worlds, win-win plans that provide prudent investment options while minimizing or eliminating fiduciary risk.
Plan sponsors often unnecessarily expose themselves to fiduciary liability simply because they do not truly understand what their duties are under ERISA. One’s fiduciary duties under ERISA can be addressed by asking two simple questions.
1. Does Section 404(a) of ERISA explicity require that a plan offer the category of investments under consideration? 2. If so, could/would inclusion of the investment under consideeration result in uunecessary liability exposure for the plan?
As for the first question, Section 404(a)1 of ERISA does not explicity require that any specific category of investment be offered within a plan. As SCOTUS stated in the Hughes decision2, the only requirement under Section 404(a) is that each investment option offered within a plan be prudent under fiduciary law. Furthermore, as SCOTUS stated in its Tibble decision3, the Restatement of Trusts (Restatement) is a valuable resource in addressing and resolving fiduciary issues.
As for the second question, Section 90 of the Restatement, more commonly known as the “Prudent Investor Rule,” offers three fundamental guidelines addressing the importance of cost-consciousness/cost-efficiency of a plan’s investment options:
The last bullet point highlights a key aspect of 401(k)/403(b) fiduciary prudence and cost-efficiency – commensurate return for the additional costs and risks assumed by the plan participant. In terms of actively managed mutual funds, research has consistently and overwhelmingly shown that the majority of actively managed mutual funds are cost-inefficient:
99 % of actively managed funds do not beat their index fund alternatives over the long term net of fees.4
Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitiors, most active managers will not and cannot recover the costs and fees they charge.5
[T]here is strong evidence that the vast majority of active managers are uable to produce excess returns that cover their costs.6
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.7
The Active Management Value RatioTM (AMVR) Several years ago I created a simple metric, the AMVR. The AMVR is based on the research of investment icons such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel. The AMVR allows plan sponsors, trustees, and other investment fiduciaries to quickly determine whether an actively managed fund is cost-efficient relative to a comparable index fund. The AMVR allows the user to assess the cost-efficiency of an actively managed fund from several perspecitives.
The slide below shows an AMVR analysis comparing the retirement shares of a popular actively managed fund, the Fidelity Contrafund Fund (FCNKX), and the retirement shares of Vanguard’s Large Cap Growth Index Fund (VIGAX). The analysis compares the two funds over a recent 5-year time period. When InvestSense provides forensic services, we provide both a five-year and ten-year analysis to determine the consistency of any cost-efficiency/cost-inefficiency trend.
An AMVR analysis can provide any amount of detail the user desires. On a basic level, the fact that the actively managed fund failed to outperform the comparable index fund benchmark immediately indicates that the actively managed fund is imprudent relative to the Vanguard fund.
Add to that the fact that the actively managed fund imposed an incremental, or additional, cost of 42 basis points without providing any corresponding benefit for the investor. A basis point is a term commonly used in the investment world. A basis point equals 1/100th of one percent (0.01). 100 basis points equals 1 percent.
So the bottom line is that the actively managed fund underperformed the benchmark Vanguard fund and imposed an additional charge without providing a commensurate return for the extra charge. A fiduciary’s actions that result in wasting a client’s or a beneficiary’s money is never prudent.8
If we treat the actively managed fund’s underpreformance as an opportunity cost, and combine that cost with the excess fee, we get a total cost of 2.06. The Department of Labor and the General Accountability Office have determined that over a twenty year time period, each additional 1 percent in costs reduces an investor’s end-return by approximately 17 percent.9 So, in our example, we could estimate that the combined costs would reduce an investor’s end-return by approximately 34 percent. This is not an example of effective wealth management.
The AMVR is calculated by dividing an actively managed fund’s incremental correlation-adjusted costs by the fund’s incremental risk-adjusted return. The goal is an AMVR score greater than zero, but equalt to or less than one, which indicates that costs did not exceed return. While the user can simply use the actively managed fund’s incremental cost and incremental returns based on the two funds’ nominal, or publicly reported, numbers, the value of such an AMVR calculation is very questionable.
A common saying in the investment industry is that return is a function of risk. In other words, as comment h(2) of Section 90 of the Restatement states, investors have a right to receive a return that compensates them for any additional costs and risks they assumed in investing in the investment. The Department of Labor has taken a similar stand in two interpretive bulletins.10 That is why a proper forensic analysis always uses a fund’s risk-adjusted returns.
While the concept of correlation-adjusted returns is relatively new, it arguably provides a better analysis of the alleged value-added benefits, if any, of active management. The basis premise behind correlation-adjusted costs is that passive management often provides all or most of the same return provided by a comparable actively managed fund. As a result, the argument can be made that the actively managed fund was imprudent since the same return could have been achieved by passive management alone, without the wasted excess costs of the actively managed fund.
Professor Ross Miller created a metric called the Active Expense Ratio (AER).11 Miller explained that actively managed funds often combine the costs of passive and active management in such a way that it is hard for investors to determine if they are receiving a commensurate return. The AER provides a method of separating the cost of active management from the costs of passive management.
The AER also calculates the implicit amount of active management provided by an actively managed fund, a term that Miller refers to as the actively managed fund’s “active weight.” Miller then divides the active fund’s incemental costs by the fund’s active weight to calculate the actively managed fund’s AER.
Miller found that an actively managed fund’s AER is often 400-500 percent higher than the actively managed fund’s stated expense ratio. In the AMVR example shown above, dividing the actively managed fund’s incremental correlation-adjusted costs by the fund’s active weight would result in an implicit expense ration approximately 700 percent higher than the fund’s publicly stated incremental cost (3.31 vs. 0.42). Based on the AER, these significantly higher costs would be incurred to receive just 12.5 percent of active management.
Using the same 1:17 percent analysis for each additional 1 percent in costs/fees, using the AER metric and the active fund’s underperformance would result in a projected loss of approximately 84 percent over twenty years. So much for “retirement readiness.”
Additional information on the AMVR can be found at my “The Prudent Investment Fiduciary Rules” blog and searching under “Active Management Value Ratio.”
Fiduciary Risk Management and Annuities I have written numerous posts about annuities on both my “The Prudent Investment Fiduciary Rules” blog and my “CommonSense InvestSense” blog. Fortunately, the inherent fiduciary liability issues can be addressed by using the same two question fiduciary risk management approach that was mentioned earlier, with the answer to both questions being “yes.” Therefore, a liability-designed 401(k)/403(b) plan will totally avoid the inclusion of annuities, in any form, within the plan.
As a former securities compliance director, I am very familiar with the questionable marketing techniques used by some annuity companies, including the ongoing refusal to provide full transparency with regard to spreads and other financial information. Both ERISA and Department of Labor interpretive bulletions have stressed the importance of providing material information to plan sponsors and plan participants so that they can make informed decisions about including annuities within a plan and about whether to invest in annuities.
The two blogs provide analyses of various types of annuities, especially variable annuities and fixed indexed annuities. My basic advice to my fiduciary risk management clients is simple – “if you don’t have to go there…don’t!”
Annuities are complex and confusing investments, with numerous potential fiduciary liability “traps.” Annuity advocates often try to further confuse and intimidate plan sponsors by engaging in technical details. I strongly recommend adopting my response – stop them before they begin and simply explain that ERISA does not require that pension plans offer annuities within a plan. Therefore, from a fiduciary risk management standpoint, there is no reason to offer any type of annuity within the plan.
Going Forward Three fiduciary risk management questions that I often ask both myself and my fiduciary clients:
Why is it that cost/benefit analysis is often used by businesses to determine the cost-efficiency of a proposed project, but yet cost-efficiency is rarely used by plan sponsors and other investment fiduciaries to determine the cost-efficiency of investments being considered by a pension plan or other fiduciary entity?
Why is it that plan sponsors will blindly accept conflicted advice from “advisers” without requiring that the adviser document the prudence of their recommendations througn prudence/breakeven analyses such as the AMVR or an annuity breakeven analysis?
Why do plan sponsors insist on making it so unnecessarily difficult and costly by refusing to see the simplicity, praticality, and prudence of the federal government’s Thrift Saving Plan?
The three bullet points remind me of one of my favorite quotes – “there are none so blind, as they who will not see.” I am not sure to whom it should be properly atttributed. The two most cited sources are the Bible and Jonathan Swift.
The point of this post is to emphasize that ERISA compliance is not that difficult to accomplish if a plan talks with the right people and approaches the compliance issues right from the start, when actually designing or re-designing the plan . If that is not possible, there are relatively simple ways to transaction into a liability-driven plan.
One of the services InvestSense provides is fiduciary prudence oversight services. By using fiduciary prudence and risk management compliance tools such as the AMVR and annuity breakeven analyses, and requiring that all plan advisers and investment consultants document their value-added proposition with such validating documents, a plan sponsor can significantly and efficiently simplify the required administration and monitoring of their 401(k) or 403(b) plan.
Notes 1. 29 CFR § 2550.404(a); 29 U.S.C. § 1104(a). 2. Hughes v. Northwestern University., 142 S. Ct. 737, 211 L. Ed. 2d 558 (2022) 3. Tibble v. Edison International, 135 S. Ct 1823 (2015). 4. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010). 5. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 6. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016. 7. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997).99 8. Uniform Prudent Investor Act, https://www.uniformlaws.org/viewdocument/final-act-108?CommunityKey=58f87d0a-3617-4635-a2af-9a4d02d119c9 (UPIA). 9. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study). 10. 29 CFR Section 2509.94-1 )(IB 94-1) and Section 2509.15-1 (IB 15-1). 11. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926.
Copyright InvestSense, LLC 2024. 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 want to applaud the Biden Administration on bringing Annuity Junk fees into the light of day to protect investors.
I want to focus on the effect of annuity junk fees in current ERISA protected defined contribution plans (I will address401(k) and 403(b) and cover rollover junk annuity fees in another article.) While the White House release mentions the savings in current plans from index annuities, I think that fixed annuities savings could be much larger over $9 billion a year. (It is important to note that fixed annuities and index annuities in government defined contribution plans in both 457 and 403(b) are not protected by ERISA and add to many more billions of dollars.)
My $9 billion a year comes from industry figures on General Account fixed annuities at $386 billion and separate account fixed annuities at $76 billion in ERISA defined contribution assets. [i]
However, it is important to note that the largest provider of fixed annuities in defined contribution plans (governed by ERISA) is TIAA, which has substantially lower fees and commissions, than the other mainstream insurance providers
Fixed annuities for the most part do not disclose fees and are rate based. For example, when a similar competitive fixed annuity in a plan like TIAA pays 4% many insurers only pay 2% – pocketing the spread. Bloomberg quoted an insurance executive bragging about these hidden 2%+ in fees at a Wall Street conference.[ii] These hidden spread fees have the same negative effect on investors that disclosed mutual fund fees have.
HOW DO I KNOW THIS I currently consult on excessive fees in insurance products. I spent 7 years making insurance products for Transamerica Life (TA), one of the largest U.S. insurance companies. I was an officer of seven different TA companies governed by four different states. I saw the need for federal intervention, as insurers had the ability to select the state regulator with the loosest regulations and lowest capital requirements.
RISKS One of the most basic fiduciary principles is diversification. Annuities make a mockery of this principle with their single entity credit and liquidity risk. [iii]
After the first annuity risk crisis in 1992 the Federal Reserve wrote a major paper on the weakness of state regulations in the insurance area. [iv]
In 2008 Federal Reserve Chairman Ben Bernanke said about these annuity products “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.”[v]Even when the federal government steped up to control risk in annuity products after the 2008 financial crisis, the insurance industry used its immense lobbying ability to thwart regulations and maximize profits. [vi]
ACCOUNTABILITY In light of recent money market rates of over 5%, these low 2-3% annuity rates in 401(k)’s in far riskier products are especially troubling, costing investors billions of dollars in retirement savings while taking much higher risks.
Hopefully, these junk fee rules will slow the growth of these high fee high risk products inside of 401k plans. The latest con game is selling annuities under the guise of Guaranteed Income. [vii]
Hopefully, this junk annuity initiative will expose some of the 401(k) target date funds which are burying index and fixed annuities inside weakly state regulated Collective Investment Trusts (CIT)s. [viii]
Hopefully, 401(k) consultants who claim to be somewhat independent will be exposed by showing how they use their insurance licenses for additional backdoor commissions.[ix]
Hopefully, within 401(k) plans they will either replace fixed annuities with diversified lower risk synthetic stable value products or at the minimum pay competitive rates like TIAA. [x]
This Biden Annuity Junk Fee initiative will save retirement investors billions. Please do not let the Insurance Industry water it down to line their own pockets.
Chris Tobe, CFA, CAIA is a national expert on excessive fees in retirement plans. He has written 4 books and dozens of articles on transparency, excessive fees & corruption in investments. His own firm Tobe Consulting has advised on over 70 ERISA legal cases on behalf of investors who have lost money through risky and/or high fee investments. He serves as Chief Investment Officer for a minority woman owned pension consulting firm out of New Orleans the Hackett Robertson Tobe group
The Investment Policy Statement (IPS) for a pension plan or other investment pool is a critical element in the governance and is a main fiduciary control on investments.
As stated in the IFEBP Investment Policy Handbook, “If an employee benefit plan does not have an investment policy statement, it does not have an investment policy.”[i] Chris Carosa, in his Forbes column, says a “401(k) IPS is a legal document that serves as the solid compliance backbone of the plan”.[ii]Josh Itzoe in his book, the Fiduciary Formula, says about an IPS, “I believe a written investment policy is the only way to demonstrate a thoughtful process and make well informed, prudent investment decisions consistent with the fiduciary requirements imposed by ERISA.” [iii]
A major U.S. regional ERISA law firm for plans remarked,
Since most plans maintain an IPS, not having one can be seen as ‘outside the lines’ and may subject the plan’s fiduciary compliance to greater scrutiny. In fact, it is not hard to imagine a plaintiff’s firm arguing that a plan’s failure to have an IPS is de facto evidence of a fiduciary breach.[iv]
In the CFA standards for Pension Trustees says “Effective trustees develop and implement comprehensive written investment policies that guide the investment decisions of the plan (the “policies”).” [v]The CFA Code assumes any investments of any size will have an Investment Policy Statement (IPS).
The Society for Human Resources Management (SHRM) outlined the percentage of defined contribution plans with an Investment Policy Statement. Basically 90% for plans over $50mm in 2008, most likely much higher today[ii] The complete breakdown was as follows:
$10 million or less – 68%
$10 million to $50 million – 78%
$50 million to $500 million – 90%
$500 million to $1 billion – 89%
More than $1 billion – 92%
I believe any plan without an IPS is in fiduciary breach and they should be reviewed annually. [i].
by James W. Watkins, III, J.D., CFP Board Emeritus™ member, AWMA®
Recent developments in the 401(k) and 403(b) litigation arena suggest that a major change is coming to said landscapes, none more so than the amicus brief that the Department of Labor’s (DOL) recently filed with the 11th Circuit in connection with Pizarro v. Home Depot, Inc. (Home Depot).
But first, a little background. First, in Hughes v. Northwestern University1, SCOTUS upheld the provisions of ERISA Section 404(a) by ruling that each individual investment option within a plan must be legally prudent. Then, in Forman v. TriHealth, Inc.2, the Sixth Circuit suggested that dismissal of 401(k) actions based on the alleged cost of discovery to plans is premature and inequitable, Chief Judge Sutton stating that
“This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth “investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares” because “the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….” Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.”3
“The fact that other courts have not suggested the use of “controlled” discovery has always interested me, it that is seems perfect for 401(k)/403(b) litigation. In controlled discovery, the plaintiffs would submit all discovery requests to the court for approval. As Judge Sutton suggested, since the only discovery that would be needed at this preliminary stage would be regarding whether the plan complied with the legal independent and objective investigation and evaluation requirement, the discovery request could be as simple as “any and all materials relied upon by the plan sponsor in determining that each investment option with the plan was legally prudent, including, but limited to reports, analyses, third-party research and analyses, notes, advertisements, articles, books, magazines and other publications.”4
The DOL Amicus Brief On February 10, 2023, the DOL filed an amicus brief (DOL brief) with the 11th Circuit in connection with the Home Depot case. I believe that the DOL’s amicus brief may be instrumental in finally creating a universal and equitable application of the ERISA in the legal system.
As a fiduciary risk management counsel, I am actually more interested in the macro aspects of the amicus brief since it would have a much broader national application. For that reason, I am not going to get into the specifics of the Home Depot case. The amicus brief gave a brief analysis of the issues involved in the case. The brief identified the question before the 11th Circuit:
“Whether, in an action for fiduciary breach under 29 U.S.C. § 1109(a), once the plaintiff establishes a breach and a related plan loss, the burden shifts to the fiduciary to prove the loss is not attributable to the fiduciary’s breach.”
The brief then addressed the issues with the district court’s ruling and the issues that the 11th Circuit should consider.
“The district court did not grapple with whether to import trust law’s burden shifting rule because it erroneously that this Court in Willett had already decided that plaintiffs exclusively bear the loss-causation burden in ERISA cases. But Willett did not even consider burden shifting, let alone reject it. If anything, Eleventh Circuit precedent—including Willett itself—supports applying trust law’s burden shifting rule to ERISA fiduciary breach cases.”5
“While Willett did not explicitly address burden shifting, other Eleventh Circuit cases have endorsed the rationale behind it. This Court has long acknowledged that ERISA “embod[ies] a tailored law of trusts” and has cautioned that courts should engage in a thorough analysis before determining that a “prominent feature of trust law” does not apply where ERISA is silent. Useden, 947 F.2d at 1580, 1581 (recognizing the “incorporation of procedural trust law principles” in ERISA). To determine whether a rule should be incorporated into ERISA’s common law, the Eleventh Circuit instructs that “courts must examine whether the rule, if adopted, would further ERISA’s scheme and goals.” 6
“Moreover, by adopting burden shifting, this Court would promote uniformity in the governance of ERISA plans by aligning with its sister circuits that already apply a burden-shifting framework for proving loss causation in ERISA fiduciary breach cases.”7
As I said, I believe that the DOL’s amicus has a far greater implications for 401(k)/403(b) litigation. The DOL’s amicus brief essentially adopted the earlier argument of both the 1st Circuit Court of Appeals in their Brotherston decision, and the Solicitor General in its amicus brief to SCOTUS. All three noted that trust law supports the idea that in cases involving a fiduciary relationship, the general rule that a plaintiff must prove all part of its cases, is replaced by shifting the burden of proof as to causation to the fiduciary/plan sponsor.
“As the Supreme Court and this Court have recognized, where ERISA is silent, principles of trust law—from which ERISA is derived—should guide the development of federal common law under ERISA. Trust law provides that once a beneficiary establishes a fiduciary breach and a related loss, the burden on causation shifts to the fiduciary to show that the loss was not caused by the breach. That is why five circuits have held that once an ERISA plaintiff proves a fiduciary breach and a related loss to the plan, the burden shifts to the fiduciary to prove the loss would have occurred even if it had acted prudently.”8
“When a statute is silent on how to assign the burden of proof, the “default rule” in civil litigation is that “plaintiffs bear the burden of persuasion regarding the essential aspects of their claims.” But “[t]he ordinary default rule, of course, admits of exceptions.” Id. One such exception is found in the common law of trusts, from which ERISA’s fiduciary standards derive. Tibble v. Edison Int’l, 575 U.S. 523, 528 (2015). Trust law provides that “when a beneficiary has succeeded in proving that the trustee has committed a breach of trust and that a related loss has occurred, the burden shifts to the trustee to prove that the loss would have occurred in the absence of the breach.”9 (citing Restatement (Third) of Trusts § 100 cmt. f}.
“As Judge Friendly explained, ‘Courts do not take kindly to arguments by fiduciaries who have breached their obligations that, if they had not done this, everything would have been the same.’”10
“This burden-shifting framework reflects the trust law principle that “as between innocent beneficiaries and a defaulting fiduciary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty.” Trust law requires breaching fiduciaries to bear the risk of proving loss causation because fiduciaries often possess superior knowledge to plan participants and beneficiaries as to how their plans are run.”11 (citing Restatement (Third) of Trusts § 100 cmt. f.)
Citing Brotherston, the amicus brief notes that
“Given that an ‘ERISA fiduciary often . . . has available many options from which to build a portfolio of investments available to beneficiaries,’ the First Circuit reasoned that ‘it makes little sense to have the plaintiff hazard a guess as to what the fiduciary would have done had it not breached its duty in selecting investment vehicles, only to be told ‘guess again.”” The court thus held that “once an ERISA plaintiff has shown a breach of fiduciary duty and loss to the plan, the burden shifts to the fiduciary to prove that such loss was not caused by its breach.'”12
“[T]rust law’s burden-shifting rule ‘comports with the structure and purpose of ERISA,’ which is “to protect ‘the interests of participants in employee benefit plans and their beneficiaries.’ To require that the plaintiff—who has already proven a breach and a related loss—also prove that the loss would not have occurred absent the breach ‘would provide an unfair advantage to a defendant who has already been shown to have engaged in wrongful conduct, minimizing the fiduciary provisions’ deterrent effect.’”13
The amicus brief went on to address the general position of federal circuit court jurisdictions with regard to shifting the burden of proof on causation in ERISA actions.
“The First, Second, Fourth, Fifth, and Eighth Circuits unequivocally hold that, once a plaintiff has proven a breach of fiduciary duty and a related loss to the plan, the burden shifts to the fiduciary to prove that the loss was not caused by the breach.14
Going Forward As I said earlier, I believe the DOL’s amicus brief has the potential to have a significant impact in 401(k) and 403(b) litigation, especially when combined with the Northwestern and TriHealth factors. While I see numerous issues that plan sponsors will need to consider, I believe that three key issues that will need to be considered are selection of and reliance on third-party consultants, reconsideration of fiduciary disclaimer clauses, and inclusion of annuities in pension plans, in any form.
While the district court cited the 6th, 9th and 10th circuits in support of not shifting the burden of proof as to causation, the DOL pointed out that in the cases cited by the district court, “the Sixth and Ninth Circuit cases did not directly address loss causation at all.”15 As for the 10th Circuit’s refusal to adopt shifting the burden of proof on causation, the DOL pointed out that the 10th Circuit’s position was purportedly based on the 11th Circuit’s misinterpretation of of its own decision in Willett.16
1. Selection and Reliance on Third-Party Consultants It continues to amaze me that plan sponsors blindly rely on the advice of mutual funds and insurance agents rather than experienced ERISA attorneys. Despite the warnings of the courts that such practices are in clear violation of ERISA, the courts have warned plan sponsors that such practices are impractical.
“A determination whether a fiduciary’s reliance on an expert advisor is justified is informed by many factors, including the expert’s reputation and experience, the extensiveness and thoroughness of the expert’s investigation, whether the expert’s opinion is supported by relevant material, and whether the expert’s methods and assumptions are appropriate to the decision at hand. One extremely important factor is whether the expert advisor truly offers independent and impartial advice.”17
“[The plan sponsor] relied on FPA, however, and FPA served as a broker, not an impartial analyst. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best. A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative. FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of “can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce.”18
Whether voluntarily or as a result of a decision by SCOTUS, I believe that there is little doubt that the Restatement’s position on the shifting of the burden of proof as to causation will become the universal rule in ERISA actions.
2. Reconsideration of Fiduciary Disclaimer Clauses They have never made sense from a fiduciary liability standpoint. They make even less sense now with the consensus position of the DOL, the 1st Circuit Court of Appeals, and the Solicitor General on the shifting of the burden of proof as to causation.
As I have explained to plan sponsors, trustees and my other fiduciary risk management clients, this is basic argument an ERISA should make in claiming that granting a plan adviser a fiduciary disclaimer clause is in itself a breach of one’s fiduciary duties.
So, you hired a plan adviser because you did not feel confident in your ability to properly evaluate the prudence of investment options for the plan; yet you agreed to provide the plan adviser with a fiduciary disclaimer clause, arguably releasing the plan provider from any liability for providing poor investment advice and harming the plan participants, resulting in the selection and evaluation being right back in your hands, and in so doing, essentially acknowledged your negligence and a breach of your fiduciary duties.
As I tell my clients, if a plan adviser feels the need to request a fiduciary disclaimer clause, in essence telling you they have no confidence in the quality of their advice, should that not raise a huge red flag for plan sponsors? Don’t go there!
3. Inclusion of Annuities in Pension Plans “Guaranteed income for life” But as my late friend, insurance adviser Peter Katt, used to say, “at what cost?”
Annuity advocates refuse to acknowledge the inherent fiduciary liability issues with annuities. With SECURE and SECURE 2.0, visions of sugarplums danced in the heads of every annuity advocate.
Annuity advocates like to try to ignore the potential fiduciary liability issues by discussing all the various “bells and whistles” that annuities offer. And I used to engage in such nonsense, forgetting the sound advice to “never argue with someone who believes their own lies.”
Even before the DOL’s amicus brief, I warned my clients that annuities were a fiduciary trap. Smart plan sponsors do not voluntarily assume unnecessary fiduciary liability exposure.
I tell my clients that whenever considering potential investment options for a pension plan or a trust, use this simple two question test:
1. Does ERISA or any other law expressly require you to include the specific investment in the plan/trust? 2. Would/Could the inclusion of the investment potentially expose you and the plan/trust to unnecessary fiduciary liability exposure?
I have been receiving calls and emails telling me that some annuity agents have been telling plan sponsors that SECURE and/or SECURE 2.0 require them to include annuities in their plans. Simply not true. I have told my clients to actually recite the two question test to any annuity agent. FYI – with regard to annuities, the answers are “no” to question number one, and “yes” to question number two.
Plan participants that want to invest in an annuity are obviously free to do so – outside the plan where there would be no potential fiduciary liability issues for a plan sponsor.
Many plan sponsors unnecessarily expose themselves to fiduciary liability exposure because they do not truly understand their fiduciary duties under ERISA. ERISA does not require a plan sponsor to offer a specific investment simply because a plan participant would like to invest in the product. Again, they are free to open a personal account outside the plan and invest in any product they are interested in.
I predict significant changes in ERISA litigation over the next two years, as SCOTUS is called on to resolve the two remaining primary issues blocking a unified standard for determining 401(k)/403(b) litigation-the ‘apples and oranges” argument and the shifting the burden of proof on causation. The 1st Circuit, the Solicitor General and the DOL have already properly decided the issues. Now all that is left is for SCOTUS to officially endorse their arguments in order to guarantee plan participants the rights and protections promised them by ERISA.
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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.
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