How to Address the (Major) Risks of Proprietary Funds in 401ks

A study by the Center for Retirement Research at Boston College in May 2018[1] found that over 40 lawsuits were then pending against financial institutions alleging self-dealing.

Many such suits involve allegations that 401k plan fiduciaries chose to offer their employer’s own investment funds that had poor performance potential, excessive fees, or both.

Some of those suits have now resolved.  Other, similar suits have been filed since.

While the use of proprietary funds in mutual fund companies is not per se imprudent, such use does raise important questions as to best practices applicable to the selection, monitoring, and retention of proprietary funds, and, therefore, their prudence.

The U.S. Department of Labor (DOL) granted financial institutions a class exemption from certain ERISA prohibited transactions in relation to self-dealing (PTE 77-3)[2] when employee benefit plans of mutual fund companies make investments in employer, i.e. proprietary, funds.

Some of the DOL pronouncements regarding this exemption and other rulemaking, provide an interesting backdrop to the issue of how plan fiduciaries of such plans should meet their fiduciary responsibilities.

PTE-77-3 was issued by the DOL at the urging of the Investment Company Institute (ICI) and, in the Notice of the pendency of the proposed class exemption[3], the DOL observed that:

In the opinion of the ICI, denial of its application for a class exemption would create a situation in which a plan covering employees of a firm specializing in investment management could not invest in the very investment vehicle managed by that firm, thus creating problems of employee morale.

Subsequently, when issuing revised proposed regulation under ERISA 404(c)[4] to relieve plan fiduciaries from liability for investment decisions made by participants in 401k plans, the DOL recognized that:

… it would be contrary to normal business practice for a company whose business is financial management to seek financial management services from a competitor, e.g., Prohibited Transaction Exemptions 77-3 and 82-63.

Thus, it can be seen that the DOL is sympathetic to the normal business practice of mutual fund companies and the impact on employee morale if such practice were to be thwarted by regulation.  However, the DOL has taken care to provide that normal business practice does not trump the ERISA duties of loyalty and prudence, by saying that reliance on the exemption does not relieve fiduciaries from the general fiduciary responsibilities of ERISA which “…among other things require a fiduciary to discharge his duties respecting the plan solely in the interest of the plan’s participants and beneficiaries and in a prudent fashion…”[5]

The question for financial institutions following normal business practice and protecting employee morale, therefore, is how to select and retain proprietary funds for the institution’s 401k plan to the exclusion of other choices, without falling afoul of the institution’s duties of loyalty and prudence?

The DOL pronouncements discussed above affirm that selecting proprietary funds is not per se imprudent.

However, the standards to which proprietary funds are subject should otherwise be consistent with the standards that apply in their absence.

So, by applying to proprietary funds the same best practices that are followed when selecting and monitoring 401k plan investments in general, we should be able to see how plan fiduciaries of financial institutions’ 401k plans are able to discharge their duties of loyalty and prudence when selecting proprietary funds.

Fund category selection

First, in establishing the investment policy statement (IPS) that will guide the investment process, the plan fiduciaries will consider what asset classes or fund categories will be represented in the plan’s fund lineup.

Here, plan fiduciaries will recognize that they must discharge their fiduciary responsibilities, in part, by diversifying the investments of the plan so as to minimize the risk of large losses[6] and they will likely invoke protection from fiduciary liability for participant investment decisions by conforming to ERISA §404(c).

This protection relies in part on the plan offering a broad range of investment options sufficient to provide participants with the opportunity to create portfolios with materially different risk and return characteristics.

For this purpose, plan fiduciaries will generally require access to fund categories appropriate to the needs of young participants, who can afford to absorb more risk in the early stages of their employment, and to the needs of those participants who are reaching retirement, who must be afforded the opportunity to reduce their risk exposure.

Generally, this calls for a broad range of equity funds, together with one or more fixed income funds, as well as a capital preservation fund, such as a money market fund or stable value fund. Also, it is a best practice to include risk-based or target date funds for participants who want the asset allocation of their account managed professionally. Target date funds represent a very common fund category which is often selected as the Qualified Default Investment Alternative.

The potential dilemma for a financial institution wishing to offer proprietary funds arises when the institution lacks a fund in an asset class that a prudent plan fiduciary would select and the institution chooses not to look elsewhere. Such circumstances place plan fiduciaries in a precarious position having regard to trust law, as described in Restatement (3^rd) of The Law of Trusts (Restatement).

The Restatement emphasizes that the fundamental fiduciary duties of trusteeship still apply where a statutory exception permits the use of proprietary mutual funds and explains in the trust setting that:

…… the trustee cannot properly confine its investments to the proprietary-mutual-fund offerings if this would impair the trustee’s ability to manage both uncompensated and compensated risk through proper diversification and through asset allocation appropriate to the particular trust.[7]

Thus, supported by trust law, it is a best practice for plan fiduciaries of a financial institution’s 401k plan to set aside normal business practice and look elsewhere to fill a fund category that a prudent fiduciary would select, where that institution lacks a prudent candidate.

Active v. passive investment strategies

Having selected which fund categories are to be offered in the plan’s investment lineup, a prudent plan fiduciary will consider whether to select funds that apply an active or passive management strategy or a combination.

Passively-managed funds generally take the form of index funds where the fund is managed to replicate the performance of a particular market index, such as the S&P 500 or the Russell 2000, by investing in the same stocks which make up the market index, whereas actively managed funds will invest in a narrower basket of investments selected as part of the manager’s strategy to outperform the market.

Best practice requires plan fiduciaries to consider the appropriateness of both philosophies as part of their due diligence in constructing a fund menu and to make a reasoned decision.

Prudent fiduciaries will take note that index funds tend to have lower investment management and trading expenses than actively managed funds and will have accumulated evidence that justifies the selection of an active manager considering the higher expenses and their potential impact on expected investment returns.

In this regard, best practice is again supported by the Restatement, which provides that:

1. Cost-conscious management is fundamental to prudence in the investment function.[8]
2. Trustees like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and cost for a particular level of expected return-or, inversely, the highest return for a given level of risk and cost.[9]
3. Active strategies… entail investigation and analysis expenses and tend to increase general transactional cost… If the extra costs and risks of an investment program are substantial, these added costs and risks must be justified by realistically evaluated return expectations.[10]

Thus, in considering funds that pursue active strategies, plan fiduciaries are bound to consider the additional transactional costs that such strategies incur when compared to passive strategies and must determine that such additional costs can be justified.

Trading costs are not disclosed by mutual funds, but a fund prospectus must disclose a fund’s turnover ratio.  This provides some insight as to trading costs and can form the basis of a reasonable method to determine their impact on returns.[11] Faced with this issue, many plan fiduciaries include index funds in a 401k investment lineup either as a substitute or as a supplemental fund choice for an active strategy.

The potential dilemma for a financial institution wishing to offer proprietary funds arises when the institution lacks a fund with one or the other strategy that a prudent plan fiduciary would select, and the institution chooses not to look elsewhere.

Fund selection and monitoring

The financial institution deciding to select funds for inclusion in the 401k plan investment menu exclusively from its own family of funds must recognize that such selection presents a conflict of interest which must be resolved solely in the interest of the plan’s participants and beneficiaries and in a prudent fashion.[12]

The conflict arises because, under the guise of fund manager, the plan sponsor is making money off of its plan participants by virtue of the management fees and other expenses borne by the plan participants through the expense ratio and recoupment of transactional costs which are deducted by the fund from investment returns before applying the expense ratio.

Accordingly, in creating the IPS, the investment committee of the financial institution’s 401k plan will want to establish criteria to govern the selection and monitoring of the plan’s investments that will prudently permit selection of proprietary funds. Best practice would require the following or similar screens:

1. Each investment option should have a minimum three-year track record.
2. The portfolio management team should have been in place for at least two years.
3. Each investment option should have at least $100 million under management, considering all share classes.[13]
4. At least 80% of the underlying securities should be consistent with the broad asset class.
5. Fees should not be in the bottom quartile of the peer group, i.e. not the most expensive.
6. Each fund should exhibit superior performance compared to applicable benchmarks and peer groups on a one, five, and 10-year basis.
7. To the extent that the investment committee wishes to consider the inclusion of proprietary funds, in recognition of the collateral benefits to the plan sponsor, a proprietary fund may be selected provided that the fund is economically equivalent, with respect to return, risk and cost, to investments without such collateral benefits.[14]

One could say that criteria g) is unnecessary given fiduciaries’ obligations to choose economically superior investments, irrespective of any collateral benefits to plan sponsors. However, criteria g) serves to remind the investment committee of the need to resolve potential conflicts prudently and in the best interests of plan participants.

As the DOL has pointed out:

Other facts and circumstances relevant to an investment or investment course of action would, in the view of the Department, include consideration of the expected return on alternative investments with similar risks available to the plan. It follows that, because every investment necessarily causes a plan to forgo other investment opportunities, an investment will not be prudent if it would be expected to provide a plan with a lower rate of return than available alternative investments with commensurate degrees of risk or is riskier than alternative available investments with commensurate rates of return[15].

 By applying these principles, a financial institution can evaluate its funds to determine the prudence of such funds as candidates for inclusion in the institution’s 401k plan investment menu.

Inclusion of funds which do not conform to such principles at the time of selection or upon subsequent periodic monitoring would be imprudent and would not address, in the best interests of participants, the conflict of interest posed by the use of proprietary funds, leading to a potential breach of the institution’s fiduciary responsibilities.

The extent of litigation reported by the Center for Retirement Research at Boston College[16] suggests that the financial service industry has not fully embraced these principles.

In summary, the selection by a financial institution of proprietary funds for inclusion in the institution’s 401k investment menu creates various potential pitfalls.

To justify such inclusion, an institution must be able to offer funds with superior performance in each fund category that a prudent fiduciary would select, and offer funds that satisfy the need for either passive or active strategies, as appropriate.

It is not within the scope of this article to consider whether any particular financial institution seeking to justify the exclusive use of its affiliated funds in its 401k plan would be able to meet the standard of care which this article discusses.

However, this article will perhaps help financial institutions and their consultants and investment advisors in assessing the hurdles they face in the selection of proprietary funds and put employees of financial institutions on notice as to how their employers may be taking advantage of them, to their detriment.[17]

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[1] (401k Lawsuits: WHAT ARE THE CAUSES AND CONSEQUENCES? George S. Mellman and Geoffrey T. Sanzenbacher, Center for Retirement research at Bost College, May 2018, Number 18-8

[2] Federal Register, Vol 42, No. 68 – Friday, April 8, 1977

[3] Federal Register, Vol 41, No. 239 – Friday, December 10, 1976

[4] Federal Register, Vol 56, No. 49 – Wednesday, March 13, 1991

[5] Federal Register, Vol 42, No. 68 – Friday, April 8, 1977

[6] ERISA Section 404(a)(1)(b)

[7] Restatement (Third) Trusts, § 78, comment c(8) (American Law Institute).  Note that the Supreme Court has emphasized the importance of trust law when looking at fiduciary responsibility under ERISA, Tibble V. Edison, 135 S. Ct. 1823 (May 18, 2015).

[8] Restatement (Third) Trusts, § 90, comment b (American Law Institute)

[9] Restatement (Third) Trusts, § 90, comment f (American Law Institute)

[10] Restatement (Third) Trusts, § 90, comment h(2) (American Law Institute)

[11] One such method was advocated by the late John Bogle.  He advocated for the calculation of the “All-In” investment expense, and suggested that an average of 50 bps should be added to an active fund’s expense ratio to compensate for trading costs.  Using th method, plan fiduciaries would have to be satisfied of an active fund’s capacity to earn the additional 50 bps back in addition to the expense ratio when selecting an active strategy. See “The Arithmetic of “All-IN” Investment Expenses”, John C. Bogle, Financial Analysts Journal, Vol 70, Number 1, ©204 CFA Institute

[12] Federal Register, Vol 42, No. 68 – Friday, April 8, 1977

[13] Criteria a), b), and c) should mitigate against the risk of an institution seeking to use its 401k plan to seed new funds.

[14] Interpretive Bulletin Relating to the Fiduciary Standard Under ERISA in Considering Economically Targeted Investments, Federal Register, Vol 80 No. 206, 65135, reinstating IB 94-01.  See also White Paper, The Prudence Standard: Affiliated Products and Services, C. Frederick Reish, Esq., Bruce L. Ashton, Esq., and Summer Conley. Esq., June 2011, Drinker Biddle, page 9.

[15] Interpretive Bulletin Relating to the Fiduciary Standard Under ERISA in Considering Economically Targeted Investments, Federal Register, Vol 80 No. 206, 65137, reinstating IB 94-01.  See also Restatement (Third) Trusts, § 90, comment f (American Law Institute), and White Paper, The Prudence Standard: Affiliated Products and Services, C. Frederick Reish, Esq., Bruce L. Ashton, Esq., and Summer Conley. Esq., June 2011, Drinker Biddle, page 9.  l

[16] (401k Lawsuits: WHAT ARE THE CAUSES AND CONSEQUENCES? George S. Mellman and Geoffrey T. Sanzenbacher, Center for Retirement research at Bost College, May 2018, Number 18-8

[17] Note that the principles addressed in this article apply similarly when a plan sponsor selects a recordkeeper who requires the use of affiliated funds as a part of a revenue-sharing arrangement.  Selecting an affiliated fund in such circumstance provides collateral benefits to the recordkeeper and the plan sponsor must establish that an affiliated fund remains prudent, notwithstanding those collateral benefits.