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
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].
The 401(k) market differs greatly by size. 85 percent of 401k plans (534 out of 631 thousand defined contribution plans) (DC Plans) are under $5 million in size. The DOL is overwhelmed with the 534 thousand plans under $5 million, of which there are enough bad actors doing engaged in highly questionable activities, such as taking participants’ money for personal use, that they have not touched the excessive fees issue, leaving it to the legal community to address such concerns. Less than 1 percent of DC Plans are over $200 million in assets and are generally cost effective to litigate.
However, less than 1 percent is still nearly 4000 plans with over $200 million each in assets. However, within this 4000, differences vary greatly by size as well. My best guess is that less than 500 actions have been filed according to what I have found. I still believe there is room for around 2500 more actions to be filed over the next decade.
An August 2022 Bloomberg article cites $150 million in settlements over the last 3 years. Bloomberg puts the number filed at around 200 since 2019 so my estimates may be conservative.[i] Bloomberg notes that decisions issued in the seven months since the US Supreme Court Hughes decision have tended to favor plaintiffs over defendants. Bloomberg predicts that “employers negotiating future settlements may be facing higher price tags than the $1 million to $5 million range seen over the past few years.” This Bloomberg article shows a growing pace of ERISA litigation.
An August 2022 article by Fred Barstein of 401kTV also predicts the rapid growth of litigation in smaller 401(k) plans. [ii]
401(k) plans of $3 billion and more assets According to my data base there are 334 plans over $3 billion in assets. This has been the most litigated group, with well over 100 actions filed. There is still a high probability of 100 or more cases coming from this group, perhaps even more if there is double dipping, as many earlier litigating plans have gone halfway at best in lowering fees.
For larger plan administrative costs, fees above $50 a head, or even one high fee option, may be enough to trigger a suit. This could apply to plans that have already been litigated once and did not adequately cut costs the first time. Does every plan option have to been prudent even those who go through to the brokerage window? If so, this could this be litigated as high fee funds and even Crypto Currency are in widely held brokerage windows.
Many of the largest plans unitize investments with defined benefit plans. Will the new level of transparency go through to target date funds with underlying alternatives like Private Equity? Alternative contracts typically contain multiple fiduciary breaches, excessive fees along with liquidity and other breaches.
401(k) plans of $1b – $3 billion
There are an estimated 717 plans between $1-$3 billion, with probably 200 that have been litigated, leaving room for maybe 300 more.
There are lots of plans with administrative costs above $50 a head, or even more with at least one high fee option, along with all the other attributes like brokerage windows like the largest plans.
401(k) plans of $500m – $1 billion There are 961 plans between $500m $1 billion, with probably only 50 or less cases litigated. This area will probably have the most explosive growth, with well over 600 plans with high fee providers. There are many higher fee insurance recordkeepers in this group and conflicted consultants, along with share class violations in many funds.
401(k) plans of $200m – $500m There are 2259 plans between $200-$500 million. 2022 will start to see a great growth in litigation in this area. Plans in this group who start fixing their plans could greatly minimize their chances of litigation. I still guess that over 1500 plans could be subject to litigation. There are even more higher fee insurance recordkeepers in this group and conflicted consultants, along with share class violations in many funds.
403(b) plans ERISA 403(b) plans include: not-for-profit hospitals, and not-for-profit universities, private not-for-profit K-12 schools. Non-ERISA 403(b) plans include public K-12 schools, public universities and some university related hospitals.
The largest 30 or so private universities 403(b)s have already been hit with litigation. Northwestern is typical with 3 different recordkeepers Fidelity, Vanguard, & TIAA. This portion of the 403(b) market with multiple recordkeepers is unique as almost all 401(k), which is more oriented toward single record keeper, so all could be litigated around administrative costs. Fidelity and TIAA also have high-cost options and TIAA has high-cost higher risk annuity options as well. The next 100 or so private universities will be at great risk of litigation.
The big wave of 403(b) litigation will probably be hospitals. While they typically only have one recordkeeper, they are much more likely than 401(k) plans of the same size to use higher fee (especially insurance company) based platforms.
401(k) plans of $50m – $200m There are an estimated 8646 plans between $50-$200 million. I predict litigation will be low in 2022 as there are so many larger targets. However, over the next decade it could pick up. This gives plans in this size range time to clean up their plans, giving maximum value to participants while minimizing litigation risk in the future.
Higher fee insurance recordkeepers, conflicted consultants along with multiple share class violations, are rampant in this group with much higher percentage.
401(k) plans of $20-$50m and $5-20m There are an estimated 14915 plans between $20-$50 million and an estimated 69343 plans between $5-$20 million. I predict that litigation involving these plans will be rare during the next 5 years, as there are so many larger targets, but over the next decade it could pick up. This gives plans in this size range time to clean up their plans, giving maximum value to participants while minimizing litigation risk in the future.
Parting Thoughts 401(k) litigation is only in its infancy, with only 15-20 percent of the 3000 potential largest complaints filed. This number could triple if the litigation goes down to plans from $50-$200 million. All of the controversy now is mostly in the largest cases being litigated. Most of these smaller cases are much more clear-cut regarding potential fiduciary violations.
Plans can fix themselves or wait to be sued. Unfortunately, many are close-minded, relying solely on conflicted advice from brokers and insurance agents that tell plans that they are OK when they actually are not. Many plans will be in for a rude awakening.
Crypto, trying to bribe its way into 401ks via Congress and with providers like Fidelity, has exposed a non-transparent dark area of 401(k) that has been on the back burner – brokerage windows. A typical plan has 12 to 16 main options, but a brokerage window could add hundreds of additional choices that so far have escaped any oversight. Fidelity stated they would put crypto as a main option and prompted this response from the DOL
“The plan fiduciaries responsible for overseeing [cryptocurrency] investment options or allowing such investments through brokerage windows should expect to be questioned about how they can square their actions with their duties of prudence and loyalty.”[i
The DOL advisory council put together a report on brokerage windows that basically said they are so immaterial, that the DOL needs to give little or no oversight to them since those in the brokerage window are aware of the additional risks.[v]
A report cites PSCSA that
23.2 percent of all retirement plans offer a brokerage window, and nearly 40 percent of those with more than 5,000 participants do. Even though brokerage windows are being offered in many plans, participants do not use them widely only 1.5 percent of plan assets are invested through brokerage windows. DOL states that custodians saw a usage ranged from .03 percent to 3 percent. [vi]
Because of their size, less attention has been paid to brokerage windows both by the DOL and the plaintiff’s bar. But with the declaration by Fidelity to offer crypto as a main option within plans and the DOL doing its job by sounding concerns, people realized that there could be crypto investing already going on in brokerage windows, with most plans not having a clue.
Fidelity, who is the largest runner of brokerage windows and who cut the deal with bitcoin to put them on their platform, are most likely receiving millions of undisclosed dollars from the crypto crowd.
Crypto is pouring millions into DC lobbying, and seems shocked that DOL did their job and did not roll over like they did with private equity investments under Trump.
Bloomberg writes that
Under that guidance, which the DOL issued last month, employers could be responsible for risky crypto trades their workers make in workplace 401(k)s. The DOL’s employee benefits enforcement agency will launch what it’s calling “an investigative program” that requires plan officials to “square their actions with their duties of prudence and loyalty” if they allow crypto investments in self-directed accounts, according to the guidance.[vii]
“This is a very damning statement about brokerage windows,” said Lisa Tavares, a partner at Venable LLP and a former IRS attorney.”
Since almost all brokerage windows have excessive fees and many have excessive risks that do not pass fiduciary scrutiny, this opens up almost any plan with a brokerage window to potential litigation.
Leading plaintiffs firm Keller Rohrback LLP is investigating whether employees and retirees have paid unnecessary fees in connection with their use of brokerage windows such as excessive fees, selecting funds based on the amount of fees shared with the brokerage firm, and selecting more expensive share classes despite the availability of less expensive classes of the same fund. They have targeted particular large firms like Continental Airlines, Kimberly-Clarke, Lilly, and Caterpillar looking for plaintiffs.[viii]
In the article, “401(k)s with Bitcoin Should Expect Lawsuits: Lawyers,” trade publication “Ignites” quotes Jerry Schlichter as saying that
Any employer who would follow the Fidelity lead by offering cryptocurrency and 401(k) plan is exposing itself to very serious risk of a fiduciary breach…. As an unproven, highly volatile investment, Bitcoin would test the prudence standard under the Employee Retirement Income Security Act….The account will carry a fee of up to 90 basis points, plus undisclosed commission fees, which would be 20 times as much as a simple index fund.[ix]
The defense bar is trying to talk up a structure the digital accounts to qualify for 404(c) protections. Schlichter, however, suggested that 404(c) protections would not provide a safe harbor anyway. He pointed to a Supreme Court decisionhanded down in January that found that plan sponsors could not escape their responsibility for allowing imprudent investments in their plans even if they feature them alongside prudent ones. Schlichter represents the plaintiffs in that case, the plan participants in Northwestern University’s 403(b) plan.Quoting Schlichter,
“[The Supreme Court] said, ‘No, the employer plan sponsor has the duty to furnish only prudent options,’ and the same applies here.'”
Any 401(k) plans with a brokerage window will be subject to severe fiduciary liability unless they can prove they have provided 100% prudent options. This will most likely lead to much more litigation and many more settlements, as the cost of proving 100% prudent options will be extremely expensive.
[v] DOL Advisory Council on Pension Benefit Plans Understanding Brokerage Windows in Self-Directed Retirement Plans December 2021 (“Brokerage Windows”).
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.
Private Equity along with other illiquid contract investments like hedge funds, private debt, real estate are a potential Fiduciary Time Bomb for plans and their participants
Center for Economic and Policy Research’s Eileen Appelbaum recently 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] from a series of articles on how the new Trump DOL rules were connected to massive political donations by the Private Equity industry.[ii]
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. [iii]
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. [iv]
Jeff Hooke of Johns Hopkins book the “Myth of Private Equity” goes into great detail on an 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. [v]
The plan as I see it is to bury Private Equity into Target Date Funds where they can hide these Fiduciary Time bombs collect the massive fees and hope that they do not blow up. Their main claim for inclusion is excessive performance which is dubious at best.
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 JP Morgan CIT, which was put in JPM broad bond CIT, with was put in a JPM stable value CIT.[vi][vii] This type of layering is what I expect to see in Target Date CIT’s.
Former SEC Attorney Ted Siedle goes over the Fiduciary Breaches common in most Private Equity funds in his Forbes Column that should make any fiduciary nervous. [viii]
1. 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.
2. Largely “unconstrained” and may change investment strategies at any time. Can engage in borrowing, or leverage, on a moderate or unlimited basis. No assurance of diversification since funds generally reserve the right to invest 100 percent of their assets in one investment. Heightened offshore legal, regulatory, operational and custody risk.
3. Myriad conflicts of interest, self-dealing practices. The investment manager determines the value of the securities held by the fund. Such valuation affects both reported fund performance as well as the calculation of the management fee and any performance fee payable to the manager. [ix] Naked Capitalism writes “The toothless and captured Institutional Limited Partners Association has proposed a fee disclosure template which has gone nowhere.”[x] It is widely known there is a massive underreporting of fees.
4. Business practices that may violate ERISA. 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. Finally, the offering documents often warn that the nondisclosure policies may violate applicable laws. That is, certain practices in which the fund’s managers engage may be acceptable to high-net-worth individuals (or unknown to them) but violate laws applicable to ERISA plans. [xi]
5. Lack of disclosure has led to numerous violations some pointed out by the SEC, others pertaining to IRS like monitoring fees tax law violations and management fee waivers tax law violations.
These 5 points are a very abbreviated list of Former SEC Attorney Ted Siedle’s column on the Fiduciary Breaches in Private Equity funds in his 8/23/20 Forbes Column. [xii]
Even a small allocation to a Target Date Fund, with the excessive risk, lack of outperformance and excessive fees seem to make it a Fiduciary Risk.
If you have underlying Private Equity or are seriously considering it, get an independent legal opinion (from a firm that does not represent PE firms) that the actual underlying Private Equity contract passes ERIA fiduciary muster. Make sure your fiduciary liability insurance covers Private Equity many do not.
While the Trump DOL “get out of jail free card” letter may protect a plan from Department of Labor action on Private Equity, you are making a dangerous bet in litigation, that the judge will block transparency and discovery of these contracts.
With no proven performance advantage, grossly excessive fees, and numerous fiduciary issues there seems to be nothing but harm in adding Private Equity into your 401(k) plan.
Chris Tobe, CFA, CAIA is an expert on Private Equity Corruption writing the book Kentucky Fried Pensions, and dozens of articles.. http://www.christobe.com/alternatives/
The CommonSense 401k Project 