Source: https://investsense.com/erisas-404c-paradox-for-participants/
Timestamp: 2019-04-18 17:20:38+00:00

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At a 2006 Department of Labor Advisory Council hearing, Fred Reish, a well-respected attorney and expert in the area of ERISA law, testified that 404(c) plans were not working, either in terms of providing plan participants with the information needed to exercise the required control over their investment accounts or in terms of providing the liability protection that plan fiduciaries desired.1 He stated that due to the growth of participant-directed accounts as the primary plan option among employers, 404(c) plans have to work and work well.
In 2012, despite recent revisions by the Department of Labor in the disclosure requirements for ERISA retirement plans and promises to protect plan participants with a new fiduciary requirement for those advising ERISA plans, 404(c) still does not work, either in terms of providing plan participants with the meaningful information they need to effectively manage their investment accounts or in terms of providing the liability protection that plan fiduciaries desire. Fortunately, only a few minor changes are needed to make 404(c) plans work for both plan participants and plan fiduciaries.
ERISA’s fiduciary standards developed from common-law trust principles, including the trustee’s duty of loyalty and prudence.4 When one compares the language from the Restatement of Trusts to the language of ERISA, the impact of trust law upon ERISA is clearly evident.
purpose, terms and other circumstances of the trust.
The comments that accompany the Restatement’s discussion on the trustee’s duty of prudence state that the duty of care includes a duty to properly investigate the particular action being considered and, when necessary, to obtain the advice of others in order to meet the applicable fiduciary standards.
The comments accompanying the Rule discuss additional aspects of the trustee’s duty of prudence, including the importance of risk management in the investment process and the importance of the effective use of diversification and the principles of modern portfolio theory in the risk management process.
The concept of Modern Portfolio Theory (“MPT”) was introduced by Dr. Harry Markowitz in 1952.8 Prior to the introduction of MPT, investment portfolios were constructed by relying on an investment’s annual return and standard deviation numbers. With the introduction of MPT, Markowitz suggested that the correlation of returns between investments should be a factor in constructing investment portfolios. By combining assets with low correlations of return, an investor could theoretically reduce a portfolio’s overall volatility and achieve more stable returns.
The importance of a proper investigation of investment options by an ERISA fiduciary cannot be overstated.
Since the Department of Labor and the courts have adopted MPT as the standard of prudence for ERISA fiduciaries, and the key factor in MPT analysis is consideration of the correlation of returns among investments as part of the portfolio construction process, it can be argued that the failure of an ERISA fiduciary to consider the correlation of returns among the investment options being considered for their plan constitutes a breach of their fiduciary duty. Therefore, the prudent ERISA fiduciary will always obtain and factor in the correlation of returns of the various investment options being considered as part of their plan’s portfolio selection process..
One area regarding disclosure of plan costs that has not been adequately discussed is the so-called “active expense” cost associated with plan investment options. There are basically two types of mutual funds – actively managed funds and passively managed, or index, funds.
Many of the investment options offered by ERISA plans are actively managed mutual funds. Actively managed mutual funds often have expense ratios that are significantly higher than those of passively managed funds. However, quite often the performance of actively managed funds is due primarily to the performance of an underlying stock market index.
Funds that display such characteristics are commonly referred to as “closet index” funds due to the extent that their performance tracks that of a relevant market index. Investors and plan sponsors can often spot closet index funds based on their high R-squared scores. R-squared is a measurement that indicates the extent to which an actively managed fund’s return is due to the return of an underlying market index, as opposed to the contribution of active management.
A fund’s R-squared score can be used to calculate an “active expense” analysis on the fund. Professor Ross M. Miller of the SUNY-Albany School of business introduced the concept an “active expense ratio,” which measures the effective cost for the active management component of a fund.20 Miller’s research found that the effective active expense ration on actively managed funds was generally five to seven times higher than the stated expense ratio for such funds.
Because an active expense analysis often indicates a much higher effective cost for actively managed funds, it can be legitimately argued that the inclusion of high R-squared score/closet index funds and their corresponding higher fees is imprudent and constitutes a breach of the ERISA fiduciary’s duties to the plan participants since an essentially equivalent return could have been achieved with a less expensive, passively managed index fund.
Under ERISA, an ERISA plan fiduciary is generally responsible for any losses incurred by the plan and/or plan participants that are due to the fiduciary’s failure to meet the applicable ERISA fiduciary standards. ERISA does provide one exception to this rule if the plan qualifies as a Section 404(c) plan.
Section 404(c) provides that a plan fiduciary shall not be responsible for the losses suffered by a plan participant to the extent that such losses are due to the control of the account by the plan participant.21 While a full review of all of the requirements required to qualify as a Section 404(c) plan is beyond the scope of this white paper, I want to focus on an area that is often overlooked and, consequently, ripe for litigation.
Three consistent themes run through ERISA: disclosure, avoidance of large losses and the importance of controlling costs. These three requirements are imposed upon plan fiduciaries in order to further the purposes and goals of ERISA, protecting and promoting the interests of employees.
Consequently, it would only seem natural and equitable that the same information that ERISA fiduciaries need to use in fulfilling their duties should be required to be disclosed to plan participant in order to meet Section 404(c)’s “informed decisions” requirement. Since an ERISA fiduciary should have this information in order to fulfill their duty of prudence, providing same to participants should not prove to be overburdening the plan fiduciary.
It can be anticipated that ERISA fiduciaries might object to the suggested disclosure requirement, claiming that plan service providers do not provide such information to the plan. Such objections are without merit..
It is a well accepted principle that a fiduciary’s duty to furnish material information to a beneficiary is a fundamental concept under the common law of trusts.34 As discussed earlier, both the Restatement and ERISA would support the disclosure of such information, especially since the fiduciary should already have considered such information in assessing the prudence of the proposed investment or investment course of action.
In his 2006 testimony, Reish pointed out that participant-directed ERISA plans “must be made to work well” given their emergence as the primary investment plan for American workers.36 While 404(c) plans are still failing to provide both plan participants and plan fiduciaries with the optimum benefits envisioned under such plans, the good news is that such benefits can be achieved with a few simple “tweeks” of the system.
Plan fiduciaries need to truly understand their fiduciary duties and responsibilities vis-à-vis the investigation, selection and monitoring of the investment alternatives chosen for the plan, as well as the providers of any educational programs. They also need to understand how to comply with the applicable standards under the fiduciary duties of loyalty and prudence, including the consideration of the correlation of returns among investments and both the stated and effective expense costs of such investments.
Next, ERISA fiduciaries need to understand that they retain full liability for plan participants’ investment losses if their plan does not qualify as a 404(c) plan, even if such losses are due to the participant’s investment decisions. Consequently, while ERISA does not explicitly require an ERISA plan to offer educational programs to plan participants, it is in the best interests of both the plan and the plan’s fiduciary to do so.
As long as the programs provides objective and meaningful information, including correlation of returns and R-squared information for each of the available investment alternatives, the educational program provides participants with the potential for better investment results, which in turn provides plan sponsors and fiduciaries with better protection against potential liability exposure.
As Reish accurately pointed out in his testimony, the “care, skill, prudence, diligence” requirements of Section 404(a) could be reasonably interpreted to require such educational programs to ensure that participants understand the information provided to them by the plan and how to effectively use such information in managing their investment accounts.38 Such an interpretation would be both consistent with and in furtherance of ERISA’s purposes and goals.
If a plan does decide to offer investment education to its participants, the plan must take steps to ensure that such programs offer meaningful and objective instruction. Failure to do so may simply legally nullify the plan’s educational efforts at compliance with ERISA’s requirements.
My personal experience as both an attorney and a compliance consultant has been that most ERISA educational attempts fall far short of complying with the applicable ERISA requirements. Most ERISA educational programs that I have reviewed involve a series of meaningless multi-color pie charts depicting model portfolios that typically do not more than provide allocation recommendations for various highly correlated, equity based mutual funds, effectively providing no downside protection for the plan participants.
Another issue with current ERISA educational programs has to do with the parties providing such services. ERISA fiduciaries are legally responsible for the selection and ongoing review of those providing educational programs to plan participants. In most cases, ERISA educational programs are provided by service providers. This creates an inherent conflict of interest issue.39 Service providers are not going to agree to provide plan participants with information that is potentially adverse to the plan provider’s interests.
The two pieces of investment information that I am suggesting need to be disclosed to participants to satisfy the “informed decisions” requirement of Section 404(c), correlation of returns and R-squared, could expose problems and conflict of interest issues within the service provider’s program. As previously discussed, most pre-packaged 401(k) plans are simply a collection of highly correlated equity mutual funds with high R-squared scores, leaving plan fiduciaries with unnecessary and unwanted liability exposure and plan participants without the broad range of meaningful, cost-effective investment options required under ERISA.
An objection often heard with regard to providing plan participants with correlation of return and R-squared data is that participants will not understand the data or how to use it. Such objections are disingenuous at best, as they go more to the effectiveness of presenting such information and the need for meaningful education rather than the usefulness of such information.
The suggestion that plan participants can effectively manage their ERISA retirement accounts with only annual return and standard deviation data suggests a return to the antiquated, pre-MPT concept of portfolio construction and totally ignores the designation of MPT by both the Department of Labor and the court as the applicable standard of prudence for ERISA fiduciaries, leaving both plan participants and plan fiduciaries at an unnecessary disadvantage.
In his 2006 testimony, Reish stated that in order for 404(c) plans to work, plans must be required to offer prudent investment options and participants to be provided with meaningful information about such investments.40 Unfortunately, those goals have not been completely met.
The bad news is that 404(c) plans still do not work, still do not provide either the plan participants or the plan fiduciaries with the desired benefits and protections. The good news is that 404(c) programs can be “fixed” by requiring that certain types of meaningful information must be provided and by recognizing the impact of inherent conflicts of interests that often exist within current informational and educational systems, conflicts of interest that prevent the disclosure of much-needed and material information to both plan fiduciaries and plan participants.
Requiring that plan participants receive a fund’s prospectus is virtually meaningless, as studies have consistently shown that investors either do not read mutual fund prospectuses or do not understand them. Asking plan participants to construct effective investment portfolios based only on annual returns and standard deviation calculations is antiquated and short-sighted, as it completely ignores the proven benefits of using MPT and the acceptance of same by both the courts and the Department of Labor.
ERISA recognizes that the keys to successful investing include effectively diversifying one’s investment portfolio to reduce to reduce the chance of large losses and controlling a portfolio’s costs. The current standards under both ERISA and the applicable regulations do not ensure that plan participants receive all of the information that they need to achieve these goals, leaving both the plan participants and the plan fiduciaries exposed to unnecessary risk.
Simply put, without correlation of returns information and R-squared scores for the investment alternatives within a plan, plans cannot meet the “informed decisions” standard required under ERISA Section 404(c). Said information is not only more meaningful than other information currently required under ERISA and the applicable regulations, but also should not be a burden for plan fiduciaries to provide since it is information that ERISA fiduciaries need to fulfill their duties of prudence and loyalty. More importantly, by providing the called for information to participants, the purposes and goals of ERISA are furthered, both for plan participants and plan fiduciaries.
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4. Harris Trust and Sav. Bank v. Salomon Smith Barney, 530 U.S. 238, 250 (2007); Jenkins v. Yager, 444 F.3d 916, 924 (7th Cir. 2006); S. Rep. 127, 93d Cong., 2d Sess. (1974), reprinted in 1974 U.S. Code Cong. & Admin. New 4838, 4865.
5. Restatement Third, Trusts, § 78. Copyright © 2007 by The American Law Institute. Reprinted with permission. All rights reserved.
6. Restatement Third, Trusts, § 79. Copyright © 2007 by The American Law Institute. Reprinted with permission. All rights reserved.
7. Restatement Third, Trusts, § 90. Copyright © 2007 by The American Law Institute. Reprinted with permission. All rights reserved.
9. 29 C.F.R. § 2550-404a-1; Department of Labor Interpretive Bulletin 96-1; Tittle v. Enron Corp., 284 F. Supp.2d 511,547-48 (S.D. Tex. 2003)(“Enron”); DiFelice v. U.S Airways, 497 F.3d 410, 423 (4th Cir. 2007).
11. Fink v. National Sav. and Trust, 772 F.2d 951, 957 (D.C. Cir. 1985).
14. 29 C.F.R. § 2550.404a-1(b)(1)(i); Fink, at 957.
16. Katsaros v. Cody, 744 F. 2d 270, 279 (2d Cir. 1984); Donovan v. Bierwirth, 680 F.2d 263, 272-72 (2d Cir. 1982).
19. Pension and Welfare Benefits Administration, “Study of 401(K) Plan Fees and Expenses,” available at http://www.dol.gov/ebsa/pdf/ 401krept.pdf.
20. Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5 No.1, (2007), 29-49.
26. See e.g., In re AEP ERISA Litigation, 327 F.Supp.2d 812, 829 (S.D. Ohio 2004); Enron, at 576, 578-79.
28. Unisys, at 447; 29 C.F.R. § 2550.404c-1(b)(3)(i)(B)(2).
29. Enron, at 578-79; AEP, at 829.
32. Central States, Southeast and Southwest Areas Pension Fund v. Central Transport, Inc., 472 U.S. 559, 570 (1985).
33. Glaziers & Glassworkers v. v. Newbridge Securities, 93 F.3d 1171, 1180 (3d Cir. 1996).
34. Glaziers & Glassworkers, at 1180.
37. Laborers Nat’l Pension v. Northern Trust Advisors, 173 F.3d 313, 317 (5th Cir. 1999).

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