If you grew up in the mid to late ‘70s, you know well the many detective movies starring Clint Eastwood. And certain phrases have become part of the American lexicon. Two come to mind, “A man has to know his limitations”, and “Do I feel lucky? Well, do ya, punk?”
One limitation with which we all struggle is that we are creatures of habit.
We get used to something and stick with it. For named fiduciaries of ERISA-covered retirement plans, Modern Portfolio Theory (MPT) may be one.
This concept has been around so long, we just take for granted that all one must do is satisfy MPT and all is well.
However, the two court cases I list in my title above are now requiring fiduciaries of participant investment-directed 401(k) and ERISA 403(b) plans to change how they traditionally benchmarked their funds.
A little history; MPT was introduced by Nobel-Prize-winning economist Harry Markowitz in a 1952 essay. His theory was that it was possible to construct an efficient frontier of optimal portfolios offering the maximum possible expected return for a given level of risk.
In other words, based upon statistical measures like variance and correlation, an individual’s return is less important than how the investment behaves in the context of the entire portfolio. Many software programs used today by investment advisors for retirement plans utilize MPT as their primary algorithm.
Primary reliance on MPT when reviewing funds for “efficiency” raises potential liability issues; not just for outside investment advisors, but plan sponsors as well.
Is MPT (remember—created 67 years ago) still relevant today? Absolutely.
But with regards to an ERISA-covered retirement plan which forces a participant to make their own investment decisions—not so much. Let us look at these two recent court cases to see how MPT, while a very valuable tool, does not work so well in most Plans today—especially if you are the named fiduciary of a participant-investment-directed retirement plan.[1]
By the way, if you are an employer or plan sponsor, that probably means YOU are the named fiduciary—even if your investment advisor is a fiduciary; unless you delegate this responsibility to an outside professional named fiduciary.
Tibble v. Edison International
It is probable that most of you are at least vaguely familiar with Tibble, a case decided 9-0 by the Supreme Court in 2015 in favor of the participant-plaintiffs.[2] The decision was based upon ERISA’s fiduciary duty, which the Court explained is derived from the common law of trusts (emphasis added).
This duty, “provides that a trustee has a continuing duty—separate and apart from the duty to exercise prudence in selecting investments at the outset—to monitor and remove imprudent trust investments.”
The American Bar Association later made this statement:
“Under Tibble, ERISA does not require the cheapest investment, but if a more expensive investment is selected, fiduciaries must document (in the minutes, consultant reports and graphs, emails, etc.) their consideration of both investments and state the reasons why a more expensive investment is in the plan’s overall best interest.”[3]
Brotherston v. Putman Investments
This case was decided by the U.S. Court of Appeals of the 1st Circuit in 20184[4]; again, in favor of the plaintiff/participants. The main thrust of this decision concerned whether the burden of proof falls to the defendant once a loss is proven. But in determining the amount of the loss, the court set an important standard.
They said that a fiduciary can “easily insulate itself” from liability by “selecting well-established, low-fee and diversified market index funds” or, for a fiduciary who desires to select funds that try to “beat the market,” it too will be immune as long as it follows a prudent selection and monitoring process.”
Along the same line of what was expressed in Tibble, the Appeals Court said that a well-established index fund is, in effect, a “safe harbor” for named fiduciaries. Again, this does not preclude the use of an active fund, but the fiduciary must prove it is prudent to do so. In January 2019, Putnam petitioned the Supreme Court to review the Appellate Court’s decision. In the Fall term that started this last October, the Supreme Court declined to review this case. For now, the 1st Circuit Appellate decision remains.
From a plan sponsor/named fiduciary standpoint, two issues are evolving:
1) The Tibble case emphasizes that retirement plan fiduciaries must use the “common law of trusts” as guidance when reviewing their plan’s investments, and must document their process to prove that a more expensive investment is prudent.
2) The Brotherston case emphasizes that retirement plan fiduciary can “easily insulate itself” from liability by using a well-established index fund.
This is right in sync with the Tibble ruling. Brotherston said, not explicitly, but implicitly—that if a retirement plan fiduciary is going to use any mutual fund OTHER than a well-established index fund, to insulate oneself from fiduciary risk (i.e. lawsuits, audits, complaints, etc.), one must be able to prove that is was prudent to use an actively-managed fund over said index fund.
Some more history—just what is the “common law of trusts?”
While it evolves from English common law and versions have been around in this country for many years, it first appeared as a set of formal rules in 1935—written by the American Law Institute (ALI).[5] Due to law changes, these rules were “restated” in 1952 and again in 1987. The current formal name for this latest set is, “Restatement of the Law 3rd – Trusts”. While not the “law,” if one looks to ERISA of 1974, much of its language regarding trust responsibilities is lifted verbatim from these ALI publications. ALI trust language has been cited thousands of times within ERISA court decisions—Tibble being just one example.
Between Tibble and Brotherston, my read is that the Courts are saying to all retirement Named fiduciaries, if you are going to use actively-managed funds, you have to prove that it is prudent to do so; AND, for you to do this you must compare an active fund to a well-established, comparable index fund. Unfortunately, many investment evaluation reports simply compare the active fund with all the other actively-managed funds in that asset class.
Here the courts are saying, in effect, they, and Restatement of the Law 3rd – Trusts, does not care about the other actively-managed funds. Each mutual fund must stand on its own; and must be compared with an appropriate index fund.
Another recent development every named fiduciary should know; effective October 31, 2019, Morningstar, with its famous (or infamous) Star Ratings, changed its system to allow fees to play a much bigger role.
Under their old system, high-fee funds that failed to beat a market index could still earn high ratings; as a result of several factors that aren’t entirely intuitive—an analyst might approve of the fund’s management process, for instance, or other “pillars” that Morningstar evaluates (people, process, parent, performance, and price). Share-class (different cost structures for the same exact mutual fund) will now make a substantial impact, causing many high-fee funds that tack on 12b-1 marketing fees or other expenses to be downgraded. If your current investment fund line-up is based on the earlier version of Morningstar ratings, NOW would be a REALLY good time to re-review.
AND, make sure each individual fund is compared to its appropriate index.
In my former life as a TPA, when a plan sponsor/named fiduciary wanted to do something “outside the norm” (a relative term, of course), I always told them the same thing; in tax court, “you are guilty until proven innocent.”
In other words, is the action worth defending? If an IRS or DOL audit ever results in governmental sanctions, how much does the named fiduciary (again, usually the Employer) want to fight the government? Even if a plan sponsor/named fiduciary is ultimately successful, it will take lots of time (months, if not years) and many thousands of dollars, as well as a few sleepless nights.
If you are your plan’s named fiduciary, it is critically important to understand just how your investments are being evaluated for their “efficiency.” Each one must stand on its own—you cannot just say we have a balanced and well-diversified portfolio of investment choices, as described under MPT. Whether you rely on outside advisors, be they fiduciaries or non-fiduciaries, YOU, as the named fiduciary, are responsible; unless you delegate the named fiduciary position to an outside expert.
So now, as the named fiduciary overseeing and being responsible for your plan’s investments, “Do you feel lucky?”
R.L. “Dick” Billings, CPC, CEBS, RF, ERPA is Director of Marketing with Arizona-based Fiduciary Wise.
[1] 29 U.S. Code §1102, Chapter 18, Subchapter 1, Subtitle B, Part 4. Establishment of Plan; (a)(1) & (2)
[2] https://www.scotusblog.com/case-files/cases/tibble-v-edison-international
[3] https://www.americanbar.org/groups/real_property_trust_estate/publications/ereport/rpte-ereport-winter-2019/erisa-thou-shall-not-pay-excessive-fees
[4] https://www.govinfo.gov/app/details/USCOURTS-mad-1_15-cv-13825/summary
[5] https://www.ali.org/publications/show/trusts/