Another belief about 401(k) plans was that plan sponsors and fiduciaries would never be sued over company stock investments because employees should be entitled to invest in their employer’s stock without the potential of fiduciary liability. That common perception was dangerously inaccurate.

More recently, a belief has developed that if a plan uses index, or passive mutual funds, the fiduciaries are protected from liability. As with the other perceptions, this reflects a lack of understanding of the fiduciary rule and its requirements. This article discusses those requirements and how they apply to the selection of investments for 401(k) plans.

 

Discussion

The myth that ERISA favors passively managed indexed investments (“index funds”) over actively managed funds is not correct—nor has it ever been. For example, the U.S. Department of Labor (DOL) has asked for comments about whether the fiduciary rules should favor index funds.1 After receiving and reviewing those comments, DOL declined to favor index funds.2 In addition—but unknown to many people, class action lawsuits have been filed against plan fiduciaries claiming breaches in the selection of both index funds and actively managed funds.3 In other words, when plan fiduciaries engage in a prudent process to select actively managed or index funds, they will be protected. However, when fiduciaries fail to use a prudent process for either actively managed or index funds, they have breached their duties.

In one case, the plan fiduciary, (a plan committee) considered adding index funds to its plan investment lineup, but decided not to. The court ruled in favor of the plan committee, saying:

“ERISA does not require a retirement plan to offer an index fund…and the failure to include either in the Plan, standing alone, does not violate the duty of prudence. See Hecker, 556 F.3d at 586 (“[N]othing in [ERISA] requires plan fiduciaries to include any particular mix of investment vehicles in their plan.”). Rather, the issue is whether the Defendants considered these options and came to a reasoned decision for omitting them from the Plan. The evidence shows the Committee did so.4”

Instead of favoring one category over another, the rules require that fiduciary advisers recommend, and plan committees select, investments that are competently managed and reasonably priced.5

While the reason for the myth is not clear, it might be due, at least in part, to the highly publicized lawsuits about excessive investment expenses. In other words, the idea that low-cost index investments are “safe” could be a reaction to those lawsuits. That’s not a correct interpretation of the law. The rules do not require that plans use the cheapest investments.6

Another reason may be a perception that index funds regularly outperform all actively managed funds. That is not correct (as discussed later in this paper), nor is it the legal standard.

 

While it is true that expenses must be reasonable, there is not a requirement that plans choose the lowest cost, or cheapest, investments or services.

 

The Prudence Requirement

While it is true that expenses must be reasonable, there is not a requirement that plans choose the lowest cost, or cheapest, investments or services. Instead, the requirement is that plan fiduciaries pay only reasonable amounts for investments and services. In turn, “reasonable” is established by the marketplace, that is, what do similarly situated plans pay for their investments? Since different, but similar, plans pay different amounts for their investments, the result is that there is a range of reasonableness.7 The job of plan fiduciaries is to engage in a prudent process to identify well-managed investments with expenses that are within the range of reasonableness.

Correspondingly, the job of fiduciary advisers is to recommend well-managed investments with expenses within that range. The prudent man rule requires nothing more, and nothing less, than a prudent process. In that context, a prudent process produces an “informed” and “reasoned” decision.8 For example, informed about the costs for investments of plans of similar sizes and informed about the qualitative and quantitative factors for knowledgeably selecting investments, and reasoned in the sense of reaching a decision that bears a reasonable relationship to those factors.

 

The Prudent Man Rule.

The prudent man rule is found in section 404(a)(1) of the Employee Retirement Income Security Act (ERISA). To quote, it requires that:

(a) Prudent man standard of care

(1) .... a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and—

(A) for the exclusive purpose of:

(i) providing benefits to participants and their beneficiaries; and

(ii) defraying reasonable expenses of administering the plan;

(B) with the care, skill, prudence, and diligence under the circumstances  then prevailing that a prudent man acting in a like capacity and  familiar with such matters would use in the conduct of an enterprise of a like character and with like aims; . . .

The key elements of the quoted language are that a fiduciary (including fiduciary advisers) must act with the skill, care, and prudence of a knowledgeable investor in the selection of investments, and that fiduciaries cannot use plan assets to pay more than reasonable expenses.

 

Regulatory Guidance.

While the Prudent Man Rule is informative, it doesn’t describe the steps to be taken in a prudent process. However, DOL regulations9 provide additional insights.

(b) Investment duties. 

(1) With regard to an investment or investment course of action taken by a fiduciary of an employee benefit plan pursuant to his investment duties, the requirements…of this section are satisfied if the fiduciary: 

(i) Has given appropriate consideration to those facts and circumstances that . . . the fiduciary knows or should know are relevant to the particular investment or investment course of action involved, including the role the investment or investment course of action plays in that portion of the plan’s investment portfolio with respect to which the fiduciary has investment duties; and 

(ii) Has acted accordingly. 

(2) … “appropriate consideration” shall include, but is not necessarily limited to, 

(i) A determination by the fiduciary that the particular investment or investment course of action is reasonably designed, as part of the portfolio . . . to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action….

While that language provides additional information, it still falls short on specifics. Importantly, though, it points out the responsibility to investigate (i.e., to determine the “relevant factors” and to gather information about those factors) and to evaluate that information through a prudent process (i.e., appropriate consideration).

To delve deeper into the process, it’s necessary to look at court cases and other guidance from the Department of Labor. Those additional materials explain that fiduciaries, and fiduciary advisers, are expected to apply “generally accepted investment theories” and “prevailing investment industry standards.”10

Generally accepted investment theories include concepts such as modern portfolio theory, diversification, strategic asset allocation, appropriate use of tactical asset allocation, and so on.

“Prevailing investment industry practices” in the selection of pooled investments (e.g., mutual funds and collective trusts) include looking at “relevant factors” such as the quality of the investment management, the depth and strength of the organization (including, for example, the analysts), the stability of the investment organization, the style of investing, and the process for investment decision-making. In other words, the selection of mutual funds for a 401(k) or 403(b) plan requires an investigation into the quality of the investment manager and its resources. The purpose of the investigation and the analysis is to make a reasoned decision about whether the investments will perform reasonably well in the future. 

 

An Informed and Reasoned Decision

Looking at the totality of the court cases, the DOL guidance, and investment industry practices, the requirement imposed on fiduciary advisers is to investigate the alternatives and to determine which investments are reasonably priced and well-managed in accordance with prevailing investment industry standards.

The results of a prudent process are an “informed” and “reasoned” decision.11 (For a decision to be “informed,” the process should identify the factors that a knowledgeable investor would consider and then gather information about these factors and evaluate that information. For a decision to be “reasoned,” the decision must bear a reasonable relationship to the relevant information.) 

In most cases, a prudent investigation and evaluation will yield a number of both actively managed and index funds that satisfy appropriate criteria. (The term “appropriate criteria” refers to the criteria commonly used by the investment industry for the evaluation of mutual funds, that is, “prevailing investment industry standards.”) In that case, they would all qualify as prudent investments. At that point, the adviser could recommend any of the qualifying investments and satisfy his or her fiduciary duties. That is because all of the investments in the group were, by virtue of a prudent process, identified as prudent. 

 

DOL Positions and ERISA Litigation About Active vs. Passive

DOL guidance and enforcement activities, as well as ERISA fiduciary litigation, provide additional insights to the prudent selection of mutual funds. 

 

DOL Activity

With regard to the former—DOL activity, the Department of Labor has never said that prudent investments are limited to passive funds, or for that matter, that they are limited to actively managed funds. In fact, that question was posed in the preamble to the proposed Best Interest Contract Exemption.12 The DOL asked if it should provide a streamlined process for fiduciary advisers where very low-cost mutual funds were offered. In posing that question, the DOL acknowledged that such a “safe harbor” could benefit index funds. After receiving responses to their inquiry, the DOL declined to favor the lowest cost funds, such as index funds, in the final Best Interest Contract Exemption.13 Stated slightly differently, the Department of Labor is agnostic about the relative merits of index funds versus actively managed funds. 

Also, in the DOL guidance on participant disclosures, the Department acknowledged that plans may hold both actively managed and index funds.14

 

ERISA Litigation

A review of ERISA fiduciary litigation produces the same result. That is, the class action plaintiffs’ firms have sued plan sponsors where they use both actively managed funds and passive index funds.15 Interestingly, while there have also been claims that plans should have used index funds, not a single court has ruled in favor of the plaintiffs on that issue. 

 

Share Class Litigation

That discussion begs the question of: With so many ERISA fiduciary lawsuits about the expenses of investments, if the claims aren’t about actively managed funds versus passive index funds, what are they about? The answer is that, for the most part, the lawsuits have been about the use of overly expensive share classes of mutual funds. Those claims have been filed against fiduciaries who use actively managed funds and index funds. In other words, the fiduciary focus should not be on whether a mutual fund is actively managed or an index fund; but instead the concern should be about selecting the appropriate share class for a plan, taking into account the total assets in the plan and the share classes that it qualifies for.16

 

Legal Conclusion

The legal conclusion is that plan fiduciaries can, through a prudent process, properly select actively managed funds for their plans. The key is to evaluate the mutual funds—active and passive—by using criteria that identifies well-managed and reasonably priced funds. 

This analysis of the law and its legal conclusions is supported by the work of other respected ERISA attorneys.17

 

The legal conclusion is that plan fiduciaries can, through a prudent process, properly select actively managed funds for their plans.

 

Academic and Industry Analysis

The debate over index funds versus actively managed funds goes beyond the prudent man rule where there is really no debate at all, since both are acceptable if prudently vetted. The debate extends to academic studies and industry analysis. Even there, though, the discussions typically revolve around the average actively managed fund and the average index fund. Keep in mind that the purpose of the prudent process is to determine which subset of funds can prudently be used. It is not to pick the average fund in either category.

With that in mind, there have been studies and published literature about the ability, with diligent research, to identify actively managed equity funds which can, over time, outperform an index.18 In addition, with regard to fixed-income funds, studies indicate that the average actively managed bond fund out-performs the average index bond fund. Again, though, the issue is not whether the average of one category outperforms the average of other categories. The issue is whether a prudent process, accompanied by diligent investigation and analysis, can identify a subset of mutual funds that are likely to perform well in the future.19

These studies support the conclusion that, when plan fiduciaries engage in a prudent process, the fiduciaries can select active or passive funds without fear of breaching their duties. Similarly, when an adviser engages in a prudent process to develop recommendations of active or passive funds, the adviser can recommend either without fear of violating his or her fiduciary duties.

 

Conclusion
When viewed in totality, the fiduciary requirements, DOL guidance and enforcement, ERISA litigation, and academic and industry studies all conclude that professional, high-quality analysis can support the selection of both actively managed and passive index funds.

To learn more, please contact your Hartford Funds representative.

1 See, Department of Labor Proposed Best Interest Contract Exemption, 80 F.R. 21960, 21978, April 20, 2015.

2 See, DOL Final Best Interest Contract Exemption, 81 F.R. 21002, 21063-4, April 8, 2016.

3 See, Pledger v. Reliance Trust Co., No. 1:15-cv-4444 (N.D. Ga. filed Dec. 22, 2015); Bell v. Anthem, Inc., No. 1:15-cv-2062 (S.D. Ind. filed Dec. 29, 2015); White v. Chevron Corp., No. 16-cv-793 (N.D. Cal. filed Feb. 17, 2016).

4 Wildman v. American Century Services, LLC, No. 4:16-CV-00737-DGK (W.D. Mo. 2019).

5 ERISA section 404(a)(1)(A) and (B).

6 See, e.g.., the preamble to the Department of Labor’s Best Interest Contract Exemption, 81 FR 21002, 21030, April 8, 2016.“Consistent with the Department’s prior interpretations of this standard, the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees….”

7 See, Dupree v. The Prudential Insurance Company of America, 2007 WL 2263892 (S.D. Fla.).

8 See, generally, Riley v. Murdock, 890 F.Supp. 444, 458 (E.D.N.C. 1995); and Fink v. National Savings and Trust Company, 772 F.2d 951, 962 (D.C. Cir. 1984). 

9 DOL Reg. §2550.404a-1.

10 See, e.g., Laborers Nat’l. Pension Fund v. Northern Trust Quantitative Advisors, Inc., 173 F.3d 313 (5th Cir. 1999); Lanka v. O’Higgins, 810 F. Supp. 379 (NDNY 1992); see also Jones v. O’Higgins, 111 EBC 1660 (NDNY 1989). 

11 See, footnote 6, supra.

12 See, footnote 1, supra.

13 See, footnote 2, supra. 

14 75 F.R. 64910, 64915 (October 20, 2010).

15 See, footnote 3, supra. 

16 See, e.g., Tibble v. Edison Int’l., 135 S. Ct. 1823, 1828 (2015); Braden v. Wal-Mart Stores, Inc., 590 F.Supp.2d 1159, 1164 (W.D. Mo. 2008) vacated and remanded, 588 F.3d 585 (8th Cir. 2009).

17 “Actively Managed Funds Remain Appropriate Investment Options for 401(k) Plans,” Saxon and Lee, 2016

18 “Long-Term Conviction in a Short-Term World,” Heugh and Fox, 2016; “Is Passive Truly the Safer Fiduciary Choice for TDFs?”, Bortz, Brown, Doyle and Walton, 2016; K.J. Martijn and Antti Petajisto, “How Active is Your Fund Manager? A New Measure that Predicts Performance,” The Review of Financial Studies, Vol. 22, No. 9 (2009) (“Cremers and Petajisto Study”) and Antti Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal, Vol. 69, No. 4 (2013) (“Petajisto Study”).

19 “Active Beats Passive,” Cammer, 2016.