W. Scott Simon
A few months ago, I wrote about the critical differences between a fiduciary under section 3(38) of the Employee Retirement Income Security Act and an ERISA section 3(21) (limited scope) fiduciary. I’d like to expand on that by focusing on why my own advisory firm serves our plan clients as a 3(38) fiduciary. While this column describes the way we came to it, there are others ways to do it as well. Remember, there are 8 million stories in the Naked City and this is only one of them.
In the Beginning
Many advisors to retirement plans are not fiduciaries, whether by simple choice (“The very word ‘fiduciary’ gives me the willies”) or because it’s beyond their control (“The business entity for which I work will not let me be a fiduciary”).
Other advisors have decided to assume a fiduciary role in their dealings with retirement plans. Before the founding of our advisory firm, my partners and I had extensive discussions about the kind of firm we wished to establish. From the outset, we agreed that we wanted one that would align our conduct with the interests of plan participants (and their beneficiaries) so as to avoid any conflicts of interest with them. Our decision to have a fiduciary relationship with participants was the best way to achieve that. Wanting to be a fiduciary in the qualified plan market naturally pointed us to the business entity that’s governed by fiduciary principles: a registered investment advisory firm.
We also wanted to assume fiduciary status to qualified plans. The ERISA fiduciary duties that must be followed by sponsors of such plans “are the highest known to law” (Donovan v. Bierwirth, 680 F.2d 263, 272 (2d Cir. 1982)) and we wished to align our conduct with that standard. That “highest” standard is derived from trust law; ERISA “federalized” the common law of trusts. Indeed, the legislative history of ERISA makes clear that the law governing qualified retirement plans is tied closely to trust investment law. (See the preamble to ERISA regulations section 2550.404a-1 and the accompanying discussion.)
The standard of trust law has been described this way: “By declaring that all retirement . . . assets are held in trust . . . [participants and their beneficiaries] are guaranteed the highest standard of conduct in the management and investment of assets for retirement that the law can establish. A trustee … carries the greatest burdens of care, loyalty and utmost good faith for the beneficiaries to whom he or she is responsible.” (By the way, the trust law standard is why the assets held in the account of a participant in a qualified plan aren’t the participant’s legally, but actually belong to the trust. The assets are held in trust and managed by the plan trustee (whose conduct is governed by the laws of ERISA fiduciary responsibility) on behalf of the participants who are beneficiaries of the trust.)
The Importance of ERISA Section 404(a)(1)
My partners and I next decided that the investment options offered to our plan sponsor clients should align as closely as possible with the law of ERISA, particularly ERISA section 404(a)(1). This section “propounds the foundational norms–the duties of loyalty and prudence–which underlie all trust fiduciary law,” notes John H. Langbein, the reporter for the Uniform Prudent Investor Act and Chancellor Kent professor of law and legal history at Yale University law school.
ERISA section 404(a)(1) describes four critical fiduciary duties: the duty of loyalty in section 404(a)(1)(A), the duty of a prudent expert in section 404(a)(1)(B), the duty of diversification in 404(a)(1)(C) and the duty to comply with all plan documents prudently, unless they conflict with ERISA. The kinds of investment options we decided to provide to our plan sponsor clients for inclusion in their qualified plans had particular relevance to two of these duties: the duty of loyalty–incorporating the duty to offer only reasonably-priced investment options–and the duty of diversification.
Passive Investment Management
It wasn’t difficult for my partners and me to decide that passively managed funds that were low in cost, and broad and deep in diversification would be just the ticket for our plan sponsor clients and the plan participants for which they are responsible. Our belief is that such funds (that is, index funds and asset-class funds) are optimal for a number of reasons.
Costs
The use of passively managed investment options by our plan sponsor clients allows them to effectively and efficiently meet one of the duties of ERISA section 404(a)(1)(A) mentioned previously: keeping costs reasonable. It is a rarely acknowledged fact–yet a commonsensical one–that the costs of investment options can be managed and controlled. Reasonably priced, lower-cost investment options allow plan participants to keep more money in their accounts for retirement than unreasonably priced, higher-cost options, all other things being equal.
My partners and I understood this simple fact from the beginning, which is why the annual expense ratios of the investment options we provide are low. But keeping such visible, explicit costs low is not enough. The invisible, implicit costs in the investment options we provide must also be low; such costs include bid-ask spread costs and market-impact costs. It does neither our plan sponsor clients nor plan participants any good if a plan investment option has a low annual expense ratio but a turnover rate high enough to burst major blood vessels. Inattention to such details can get sponsors in legal trouble and can harm the retirement of plan participants. Both undesirable outcomes can be avoided with the help of thoughtful advisors.
Our belief from the get-go, then, was that participants should not pay retail for investment options in their 401(k) plans when institutionally-priced options are readily available to them. But even some giant companies (which often deliver excellent values otherwise) don’t understand this simple fact. For example, it was alleged in the current ERISA litigation against Wal-Mart that the company’s 401(k) plan (purportedly America’s largest based on the number of participants: over one million) offered participants only retail-priced investment options, and particularly high cost retail-priced funds to boot. This kind of lunacy is decidedly harmful to plan participants–who, after all, are the center of the ERISA universe given the great “sole interest” and “exclusive purpose” rules that underlay the duty of loyalty in ERISA section 404(a)(1)(A).
Plan sponsor behavior like Wal-Mart’s serves as a warning to all plan sponsors: “Wasting [participants’ and] beneficiaries’ money in imprudent,” as commentary to the Uniform Prudent Investor Act notes. The U.S. Department of Labor states in its guide called A Look at 401(k) Plan Fees for Employees: “Any fees and expenses paid by qualified retirement plans must be reasonable relative to the level and quality of services rendered by service providers. After careful evaluation during the selection stage, the plan’s fees and expenses must be monitored on an ongoing basis to ensure that they continue to be reasonable.” Our firm pays attention to such matters which is why we provide our plan sponsor clients with only passively managed investment options for their retirement plans with low explicit and implicit costs.
Risk
Another reason why my partners and I decided to offer only index funds and asset class funds for inclusion as investment options in the retirement plans offered by our plan sponsor clients is that doing so allows them to effectively and efficiently meet another of the duties of ERISA section 404(a)(1)(C) mentioned previously: diversifying risk broadly.
Just as the costs of investment options can be managed and controlled, so, too, can their risk–although this fact is little understood. The passively managed funds we provide to plan sponsors allow plan participants to minimize, in times of market turmoil such as 2008 and 2009, the relative size of the reductions in value of their retirement plan accounts in comparison to other less broadly diversified funds. Broader diversification can minimize reductions in account values–and lead to enhanced increases in account values in subsequent market recoveries. In short, downturns can be shallower and upturns steeper.
Diversification of risk–when done properly–actually has much more value to plan participants at the portfolio level than at the fund level. This fact arises from the insights of Modern Portfolio Theory that underpin the investment provisions of ERISA (see ERISA Interpretive Bulletin 94-1: ” … any models or materials presented to participants or beneficiaries will be consistent with widely accepted principles of modern portfolio theory … “).
From the very beginning, my partners and I decided to incorporate the Nobel-prize-winning principles of MPT. This required us to diversify broadly at two different levels: diversification across all the funds that we have assembled in a portfolio (which we term “horizontal” diversification) and diversification within each such fund of the portfolio (which we term “vertical” diversification) (see the Department of Labor publication “Meeting Your Fiduciary Responsibilities”).
Offering low cost and broadly diversified passively-managed portfolios to our plan sponsor clients for inclusion as plan investment options allows participants to keep more money in their retirement plan accounts. While it’s obvious that low costs allow participants to keep more money, how does broad diversification help do that? The answer lies in a little-known mathematical rule known as variance drain. “Variance” is a measure of portfolio risk. “Variance drain” holds that, as between two portfolios with the same beginning value and the same average return, the one with the greater variance (i.e., volatility or fluctuations in its value over time) will have a lower compound return and thus fewer dollars at the end of the period in question.
Stated in a positive way, reducing a portfolio’s variance–that is, minimizing the size of fluctuations in the value of the portfolio–can enhance portfolio compound return which means greater portfolio dollars in comparison to less diversified portfolios. That’s another reason why we decided to provide our plan sponsor clients with a risk-based series of broadly diversified model portfolios of passively managed funds. Each such low cost portfolio, comprised of thousands of securities from dozens of countries, is automatically rebalanced annually. Retaining our focus on the law of ERISA by providing these portfolios to our plan sponsor clients also allows them to minimize the “risk of large losses” as is normally required by the diversification rule of ERISA section 404(a)(1)(C).
Active Investment Management and The Random Variable of Return
Just as it’s a fact that investment costs and risk can be managed and controlled, it’s a fact that the return earned by an investment cannot be managed or controlled. The reason why is that return is merely a random variable and therefore unpredictable. In fact, no one really know what the return will be for any given investment from one year to the next, one month to the next, one week to the next, one day to the next or even one minute to the next. Those that profess to possess such clairvoyant powers–known as active investors engaged in stock picking, market timing and/or track record investing–are often able to convince others to hand over money to them in exchange for the (hoped-for) fruits of such fortune telling.
The problem with active investing is that virtually every reputable study of investment performance over the last 40 years has confirmed that it is not a very useful exercise–at least for investment clients. For example, track-record investing (which is one form of active investing) is the belief that an investment superior in the past will be superior in the future. Yet there’s no reliable way to predict when–or which–or even if–superior-performing investments from the past will be superior again in the future. In fact, data show the perverse tendency for the track record of an investment superior in the past to be followed by a track record inferior in the future. No wonder the Securities and Exchange Commission requires all advertisements for mutual fund to carry the warning: “Past performance is no guarantee of future results.”
My partners and I freely admit that there are skillful stock-pickers, market-timers and track-record investors out there. An endless number of studies have shown, however, that the costs and risks associated with trying to identify such wizards in advance before their superiority shows up more than outweigh whatever extra returns they may achieve over time. Increased risks and higher costs, which are associated with many active investment strategies, are precisely the dangers that ERISA warns plan sponsors to avoid. We decided from the beginning that we wouldn’t subject our plan sponsor clients and their plan participants to such dangers.
This led us to reject active investing for our clients and embrace passive investing. This decision had nothing to do with the relative “efficiency” of financial markets. What’s of much greater importance to us than whether a well-known fund manager is more “nimble” in an “inefficient” market (we believe that most such managers end up inferior given the crushing costs, illiquidity, sky-high risk, etc. they face in less efficient markets) is the fact that financial markets are zero sum games and that, as the legendary John Bogle keeps reminding us, “costs matter”–just as “risk matters.”
The ERISA Section 3(38) Investment Manager
A 3(38) fiduciary receives and accepts, via a written contract from the plan sponsor (in which the 3(38) is required to plainly acknowledges its status), delegation of the sponsor’s duty to select, monitor and (if necessary) replace the investment options in a qualified retirement plan. This delegation is of immense value to a plan sponsor since it allows the sponsor to get rid of a significant amount of risk. There can be no doubt about the value of a 3(38) fiduciary: it has committed itself as a 3(38) in a written contract and unambiguously accepts the duties described in ERISA section 3(38).
A brief review of on-going ERISA litigation shows that plan investment options, one way or the other, are always a major issue and often the central one. My partners and I felt that it was a no-brainer to become a 3(38) fiduciary given the prudence of our approach described in this month’s column, particularly the prudence of the investment options that we provide to our plan sponsor clients.
Can Broker-Dealers Be 3(38) Fiduciaries?
ERISA allows only banks, insurance companies and registered investment advisors to be 3(38) investment manager fiduciaries. At first blush, then, it would appear that a broker-dealer cannot participate in the retirement plan market. But every broker-dealer has a registered investment advisor arm. This means that, with management’s permission, registered representatives of broker-dealers that are interested in entering the 3(38) market could morph into investment advisor representatives of the registered investment advisor arm and participate in it.
If management won’t allow this, then registered representatives who are interested in entering the 401(k) plan market or are already in it can offer plan sponsors the services of an ERISA section 3(38) fiduciary via a third party. This allows registered representatives to participate in the 401(k) market and get paid without having to be a 3(38) fiduciary–or any fiduciary for that matter.
A Word About Process
It is often said that what’s important in modern prudent fiduciary investing is process, not (performance) results. While true, process can sometimes become procedurally hollow due to the absence of critical thinking and the presence of a mindless checklist. It does plan participants no good if the boxes are all checked properly but the investment options are still lousy with high costs and poor diversification, both of which lead to inferior returns and less money in retirement plan accounts.
But if you adopt the kind of approach described here, you get the best of both worlds: not only is the process prudent (and simpler) but the results are superior. The totality of this approach achieves two important goals at the same time: it not only enhances wealth for plan participants but also helps to minimize risk for plan sponsors. Getting it right for plan participants, then, also gets it right for plan sponsors, and vice versa.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.