Editor’s note: This is the second in a two-part series. The first installment appeared here.
In my last column, I argued that when ERISA diversification requirements are met, the only remaining prudence issue is price and that, regarding an asset (e.g., stock in a company) that is traded in a liquid and transparent public market, that price is determined by the market. When the fiduciary pays no more than that market price, ERISA’s prudence standard is satisfied. The (unanimous) Supreme Court decision in Fifth Third Bancorp et al. V. Dudenhoeffer says as much, in so many words.
That solution to the “good” vs. “bad” asset issue leaves (at least) three issues open: What, then, does ERISA’s diversification rule require, especially in the context of a participant directed DC plan? How might ERISA’s (separate) fiduciary duty of loyalty affect fiduciary decision making, e.g., regarding ESG investments? And if these principles apply at the level of individual stock purchases, how do they apply at the fund level?
Starting With the Bottom Line
In what follows I discuss these issues and some of the subtleties they present. But as a kind of roadmap, I thought it would be useful to begin with a summary.
Simply to repeat the starting premise: Per my prior article, where ERISA’s diversification rule is satisfied, the only remaining prudence issue is price—did the fiduciary pay a “prudent” price for the investment? When the investment is in a security traded in transparent and liquid market, the market price is by definition prudent.
- ERISA’s diversification rule requires, generally, that fiduciaries: (1) reduce the risk of large losses; and (2) construct a portfolio with a risk/return on the efficient frontier. In participant choice plans, these requirements must generally be satisfied at the fund menu level and allow participants to pick (more or less) where on the efficient frontier they want to be.
- ERISA does not prohibit investment in any asset class, but fiduciaries must consider the effect of investment in a particular asset class on the portfolio’s risk/return profile.
- Where an investment is objectively prudent (it satisfies the market price and diversification requirements) and the fiduciary has no direct pecuniary or personal (e.g., a transaction with a relative) interest in it, a breach of the ERISA duty of loyalty is in effect a “thought crime” and not amenable to legal regulation.
- Where, as in the typical 401(k) plan, investment is in a fund (e.g., a mutual fund or collective investment trust), the plan/participant is in effect paying the fund manager to invest, which is why 401(k) prudence litigation focused on fees has had traction. Claims based on “underperformance” are more problematic, since they are always based on retrospective analyses, whereas the fiduciary is always acting prospectively.
ERISA includes a separate requirement that a plan fiduciary diversify plan investments “so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.” In addition, ERISA’s prudence requirement is also understood to require diversification.
ERISA’s diversification requirements may be understood both as a defense against “the risk of large losses” and (what may be considered the same thing) as implementing the modern portfolio theory concept that diversification may reduce risk without reducing return.
Real estate, private equity, hedge funds and even crypto may provide creative ways to reduce certain kinds of risk or maximize certain kinds of return, and may serve that function in a well-designed portfolio. But practically all that diversification requires as a general matter (and absent special circumstances) is that the plan’s portfolio include a sufficiently diverse collection of uncorrelated risks to put it somewhere on the “efficient frontier,” defined as “the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.”
In a participant choice DC plan, it is generally understood that the choices offered to participants in the fund menu must enable the participant to construct such a portfolio that fits their own risk tolerance.
The Department of Labor’s regulation under ERISA section 404(c) provides a roadmap for participant choice plans in this regard. It generally requires that the plan provide “[a]t least three of the investment alternatives … which constitute a broad range of investment alternatives.”
For example, while there are special issues with respect to collectibles, ERISA generally does not prohibit any specific sort of investment. The overall effect on a portfolio’s risk/return profile must, however, be considered when adding any particular sort of investment.
It does not appear to me that when, for example, a cryptocurrency is traded in a transparent and liquid market, it could not play a role in a “prudent” portfolio in the same way that shares of Tesla, or Game Stop or even Facebook might. Consideration should simply be given to this investment’s effect on the portfolio’s risk/return profile.
Duty of Loyalty
ERISA also imposes a duty of loyalty on plan fiduciaries. The duty of loyalty has been raised as an issue regarding private equity investment (in the Intel litigation) and regarding ESG investments.
It’s not really a secret that ESG is associated with certain ideological commitments. This is most acute concerning climate change, for which the “E” in ESG has come to stand. The question then arises: If a plan makes a substantial commitment to corporations with vigorous climate change policies to which the plan’s fiduciaries are also personally committed, are the fiduciaries acting “for the exclusive purpose of providing benefits to participants” or are they using plan assets to further their personal views?
When the prudence of an investment is a given—for example, if the stock in ABC Solar Solutions is purchased at a market price and does not negatively affect the portfolio’s risk/return profile—and the fiduciary has no pecuniary or direct personal motive (e.g., when the investment involved a relative), I find it very difficult to parse this issue. It is, in the end, kind of political—in the sense that I would expect that to the extent that a fiduciaries’ personal commitments play a role in decision making, they may be understood to reflect the commitments of the “plan participant community” as a whole.
It is also impossible to prove that a fiduciary made an otherwise prudent investment for personal reasons. Except when the fiduciary had a pecuniary or direct personal interest.
Thus, I wouldn’t expect a solar company’s plan to be invested heavily in big oil, in the same way that I would not expect a U.S. automaker’s or supplier’s plan to be invested heavily in foreign car companies.
How Do These Principles Apply to Funds?
I’ve highlighted this question because in the end, it is at the heart of all 401(k) prudence litigation. Taking this step by step: A fund of stocks purchased at a market price is, per the analysis above, not “imprudent.” One reason plaintiffs’ litigators have focused so much on the “prudence” of fees, and only recently have begun attacking the “prudence” of performance, is that when a participant invests in, e.g., a mutual fund, she is in effect paying the fund manager a fee (i.e., the expense ratio) to buy stock for her.
It seems to me that the fee cases come down to a question of proof—how do you prove a fund (the fund manager’s stock-buying services) is “overpriced?” The easiest way to do that has been to compare the fund’s fees to an identical lower priced alternative. Thus, plaintiffs’ lawyers have attacked fiduciaries when the fund share class offered in a fund menu carries a higher fee than an available alternative share class. In effect, the fund manager is being paid more to “buy the same stock.” In this regard, the plaintiffs’ lawyers have sought to extend this analysis to different vehicles, e.g., collective investment trusts, that “buy the same stock.”
I’m just explaining how the statute frames these issues—obviously there are a host of other issues in fee litigation, including search costs, revenue sharing and different regulatory regimes.
Finally, regarding more recent challenges based on a fund’s “underperformance,” a much more difficult set of questions is presented. First, every one of these cases involves a retrospective analysis, which I thought was considered an inappropriate way to judge a fiduciary’s prudence. This sort of analysis is fundamentally unfair to fiduciaries, who have to make their decisions prospectively.
Second, absent demonstrable manager incompetence (or perhaps something like style drift), I don’t really see that “underperformance” is provable as imprudence. Returning to the analysis we began with, all of the stocks in a fund’s portfolio were (one assumes) purchased at the market price and are still selling at a market price. Per
Fifth Third Bancorp et al. V. Dudenhoeffer, in a transparent and liquid market, there’s no way to “prove” prospectively that tomorrow a stock (or a bundle of stocks in a fund) will be worth less than it is today.
For the last decade, U.S. large caps have outperformed nearly every other asset strategy. That doesn’t mean that those alternative strategies are imprudent.
In these two articles, I have tried to outline what I believe is ERISA’s statutory framework for analyzing a set of fiduciary issues that are beleaguering our retirement savings system, including attacks on specific asset classes (e.g., private equity), disputes over motivated investing (ESG) and the now-massive 401(k) litigation industry.
Bottom line: Sticking to the statutory framework should make a number of these issues simply go away. At a minimum, it would clarify what we are arguing about.
Michael P. Barry is a senior consultant at October Three and President of O3 Plan Advisory Services LLC, which provides retirement plan regulatory analysis targeted at plan sponsors and those who provide services to them.
Opinions expressed are those of the author, and do not necessarily reflect the views of ASPPA or its members.