Ayres may not have it all letter perfect but his basic points have a legal basis

August 19, 2013 — 5:27 AM UTC by Guest Columnist Ron Rhoades

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Brooke’s Note: That giant whooshing sound emitting from some disembodied space wasn’t God’s bicycle tire. It was the collective sighs of relief coming from the bosoms of America’s employers as slowly they have been allowed off the hook of providing pension plans of the defined benefit variety for over 30 years. Providing certain retirement benefits to staffers whose lifespans are of indefinite length is an element of open-ended risk that no employer wants. What might have been reassuring to plan participants of these 401(k)-type plans swapped in for DB plans was that the employers were still, legally speaking, pretty much still on the hook. Gone were the annuity benefits of DB plans but in their place was supposed to be the promise of professional level investing as assured by nasty ERISA provisions. But then that promise never quite got fulfilled and we are shocked, shocked that a retirement crisis is arising — and how dare a Yale professor stick his nose into all this! In this piece by Ron Rhoades, he explains how the outrage and even correct criticisms of Ayres’ study are really no match for the greater reality that plan sponsors conveniently outsourcing their fiduciary duties to, in many cases, a bunch of salesmen (who provide kickbacks) may be living on borrowed time. And, plan sponsors, he offers a sweet little remedy: Hire a plan consultant who is a 'fiduciary’ (most frequently an RIA) and puts their promise of fiduciary care in writing. Fiduciary, by my reading of this piece, means the plan consultant will take a the legal bullet in the event of a lawsuit and will avoid that bullet by providing low-cost products and a sensible approach.

Unknown to most plan sponsors, many “retirement plan consultants” charge excessive fees (in my view) for advice that is often conflicted and results in additional compensation for the retirement plan consultant.

Rarely is this advice truly “expert,” for often little due diligence has been undertaken with respect to the funds recommended for the 401(k) or other plan. The result is often high-expense mutual funds and other investment choices provided to plan participants. See: What RIAs must know about hidden, and excessive, fees in serving as fiduciaries to a 401(k) plan.

As is well known in the investment industry, substantial academic evidence supports the conclusion that, on average, the fees and costs of a mutual fund possess a direct inverse correlation to the likely long-term returns of mutual funds, when compared with oness with similar investment strategies. Executives of broker-dealers and insurance companies may deny their knowledge of this simple truth, but we don’t have to believe that they are so ignorant.

In essence, investing in mutual funds is not (as many unknowledgeable plan sponsors might believe) bound by the principle that “you get what you pay for”; sadly, when higher fees and costs are incurred, returns to the investor are nearly always lower over the long term. See: One-Man Think Tank: A method for analyzing and comparing the costs and fees for mutual funds and ETFs.

I like to explain it to clients in this fashion. Suppose you owned a horse entered in a horse race. In most horse races all jockeys possess the same weight; generally speaking, this is done by adding weight to some horses to bring the burden all horses possess to the same level.

But suppose your horse has been given an extra 25 pounds more to carry than the other horses. Does this mean that the horse cannot win the race? Not necessarily; it is possible that a strong (or lucky) horse can win the race. But … the longer the race, the more the impact of that extra weight. This makes it extraordinarily difficult for the horse with the extra weight — or the fund with the higher fees and costs — to prevail over the long term.

Ayres’ letter and a response thereto

In June, Yale law professor Ian Ayres sent letters to some 6,000 retirement plan sponsors warning them that based upon his study, they may be subject to potential liability due to providing investment options with excessive fees. See: 401(k) industry flummoxed over Yale professor’s 6,000 'threatening’ letters to plan sponsors.

(The white paper upon which the letter is based, written by Curtis Quinn and Ayres, can be viewed here).

In discussing Ayres’ letter to plan sponsors and his study with several of my investment adviser colleagues recently, there was general agreement that the letter and study are significant in that it alerts many plan sponsors to potential liability. It puts these plan sponsors on notice that the plan sponsor (usually a small-business owner) is ultimately responsible for the decisions made with regard to investment offerings under the plan, and that they should scrutinize the quality of the “advice” they receive carefully. See: Why the 'naked fear’ from a Yale law professor’s letters to 401(k) plan sponsors is still present.

Ayres’ analysis has limitations, as ERISA expert and attorney Fred Reish, with two colleagues from Drinker Biddle & Reath LLP, points out in an open letter. But of course, any study has limitations; data sources are never perfect, and are often not as current as one would like. And the level of services provided to a plan sponsor or the complexity of the plan may vary (although in my view they don’t vary all that much to justify substantially higher fees in most cases).

Plan sponsor might ought to err on the side of heeding Prof. Ayres alarming letter.
Plan sponsor might ought to err
on the side of heeding Prof.
Ayres alarming letter.

Be calmed at your peril, plan sponsors

Ayres’ letter should not be viewed as a definitive conclusion that a fiduciary duty was breached by any particular plan sponsor. However, plan sponsors should not be calmed by such an assurance. As noted by Reish, et. al., in the concluding paragraph of their open letter: “Plan sponsors do have a fiduciary duty to prudently monitor plan and investment expenses. If they have not compared their costs to market data in the last two or three years, they should do that now … particularly in light of last year’s 408(b)(2) disclosures.” See: Why 408(b)(2) is a flop for the 401(k) business and how RIAs can turn it around.

I hope that, in the end, Ayres’ letters and white paper, and the substantial response from the industry thereto and the debate triggered, may ultimately bring forth a good result. I would hope that a wave of plan sponsors question the validity of the current “advice” they receive.

Hopefully many plan sponsors will now look for advice they can rely upon from fiduciary advisors, rather than the advice received from non-fiduciary consultants (who dominate the provision of investment counsel in much of the defined-contribution market). Moreover, plan sponsors should carefully review the results of benchmarking of fund fees and expenses, and should ensure that the fees and costs of the funds on their platform are in line with, or lower, than the benchmark averages.

The end result, if plan sponsors adequately heed Ayers’ warning, will be the replacement of expensive mutual funds with much lower-fee mutual funds in defined-contribution plans. See: Fidelity Investments puts hard numbers on the disgruntlement of 401(k) plan sponsors — and launches Z shares with ETF-like prices.

Taken in aggregate, the savings to plan participants could be billions, or tens of billions of dollars, each and every year. This would greatly aid the retirement security of our fellow Americans. See: An X-ray of one affluent, educated and sophisticated investor’s portfolio shows how it was chewed up by fees.

Business owners should support the fiduciary standard for all providers of investment advice to retirement plan sponsors

The burden on plan sponsors — business owners attuned to running their own businesses but rarely possessing a sophisticated knowledge of investments — is quite high. The Employee Retirement Income Security Act of 1974 demands that fiduciaries act with the type of “care, skill, prudence, and diligence under the circumstances” not of a lay person, but of one experienced and knowledgeable with these matters.

The real tragedy for plan sponsors occurs when private litigation arises against plan sponsors (including class-action litigation by plan participants, just this month made easier by a decision in the 7th U.S. Circuit Court of Appeals. Alternatively, and largely in response to complaints by plan participants, a Labor Department audit can result in an enforcement action and/or restitution to plan participants. In such instances, the plan sponsor (a small-business owner, typically, although larger-business owners also are at risk) is held to account. See: What a wave of 401(k) lawsuits tell us about what RIAs really need to worry about.

Yet — and here is the rub — the plan sponsor has great difficulty holding the “retirement plan consultant” to account, given the low standard of conduct applicable to measure the potential liability of a non-fiduciary consultant. The plan sponsor is the victim of poor (and non-fiduciary) advice.

Indeed, usually the plan sponsor (business owner) has substantial monies invested in the retirement plan and suffers personally from the poor investment choices contained therein. But, in the end, the plan sponsor is often the one on the hook — and the “retirement plan consultant” is off the hook by not being considered a fiduciary to the plan.

It should be noted that such cases are not rare. The courts have recently been far more receptive to “excessive fee” cases arising under ERISA against plan sponsors. Recent court decisions, including those of Abbott v. Lockheed Martin Corp, (7th Circuit, Aug. 7, 2013); Tussey v. A.B.B. Inc. (W.D. Missouri, March 31, 2012); and Tibble v. Edison International (March 21, 2013), may each be regarded as a “watershed moment for fiduciaries to understand their duties regarding the requirement to prudently select funds, even 'conservative’ funds, such as SVFs,” in the opinion of Thomas E. Clark Jr., J.D., LL.M., CCO/director of fiduciary oversight of Fiduciary Risk Assessment LLC (FRA) and PlanTools LLC.

Of course, plan sponsors routinely in fact rely upon the advice provided by the non-fiduciary “retirement plan consultant.”

This was evident in the Tibble v. Edison International case (currently undergoing re-hearing at the appeals court level), in which the 9th U.S. Circuit Court of Appeals stated: “Since at least 1999, Edison has contracted with Hewitt Financial Services ['HFS] for investment consulting advice. It argued below, and re-urges here, that it reasonably depended on HFS for advice about which mutual fund share classes should be selected for the Plan … HFS frequently engages with the Investment Committee staff at Edison to help design and manage the Plan menu. It applies the investment staff’s criteria: (1) fund stability/management, (2) diversification, (3) performance relative to benchmarks, (4) expense ratio relative to the peer group, and (5) the accessibility of public information on the fund. HFS then approaches the Committee with options and discusses their respective merit with its members. And to keep Edison abreast of developments, it provides the Committee with monthly, quarterly and annual investment reports … the district court found that Edison failed to satisfy [the requirement of] reasonable reliance. We agree. Just as fiduciaries cannot blindly rely on counsel … a firm in Edison’s position cannot reflexively and uncritically adopt investment recommendations.”

Hewitt on the hook

From the decision, it is unclear if, at the time, Hewitt Financial Services LLC was a fiduciary to the plan sponsor, Edison. This matters a great deal. If Hewitt Financial Services LLC was not a fiduciary at the time to the plan sponsor, Edison, recovery by the plan sponsor for the poor advice provided by this “consultant” would be doubtful. The low (suitability and other) rules of conduct governing the actions of Hewitt Financial Services LLC (currently a broker-dealer, but not registered as per the SEC website as of Aug. 7 as a registered investment advisor) simply would not support a likely claim by the plan sponsor against a non-fiduciary consultant. See: The RIABiz list of winners and losers in the wake of the SEC’s fiduciary study.

The unfairness of all of this — the lack of an adequate remedy for the plan sponsor who relies upon the “retirement plan consultant” — is a valid reason the DOL is seeking to move forward with its new “definition of fiduciary” rule. That is, to correct the inequity that a plan sponsor (also a victim, in many instances) is held to liability in excessive-fee (and other forms of) cases in which the plan sponsor can seldom hold the (non-fiduciary) retirement plan “consultant” to account for the advice provided.

Plan sponsors should not be placed in this untenable position. The DOL’s proposed rule would correct this problem, by ensuring that all providers of investment advice to plan sponsors are fiduciaries under the law and can be held accountable as such. Moreover, both large and small businesses should support the DOL’s rule-making efforts. See: 9 things advisors to 401(k) plans must do to keep clients out of hot water.

Only businesses associated with the sell-side broker-dealer and insurance company communities would find support of the DOL’s rule-making efforts objectionable. Indeed, in one of the great deceptions of our time, currently in Washington, D.C., the lobbyists are rolling out “small businesses” that would be “hurt” by the imposition of fiduciary standards upon retirement plan consultants. Who are most of these “small businesses” being paraded in front of Congress and the Office of Management and Budget? The non-fiduciary retirement plan consultants, themselves — the ones whose fees are nearly often excessive, and whose conflict-ridden advice places all other business owners at risk! See: Two advisors debate the financial viability of serving as a fiduciary to small accounts amid DOL’s new rules.

Should plan sponsors ever rely upon a non-fiduciary consultant?

If, as is nearly always the case, the plan sponsor is not able to properly discern the fees and costs of mutual fund products (or at least properly estimate them), the plan sponsor should obtain advice.

But, in such circumstances, can a plan sponsor turn to a non-fiduciary “retirement plan consultant” for advice? While I am not ready to say that plan sponsors cannot, per se, rely upon non-fiduciary retirement plan consultants, I believe plan sponsors put themselves at great risk if they choose to do so.

In essence, a fiduciary — the plan sponsor — can only fulfill its obligations properly (and with a high degree of confidence) if, in the selection of an investment consultant, it considers the consultant’s qualifications. And, if the investment consultant is not bound to act as a fiduciary to the plan sponsor, the plan sponsor has no business relying upon the advice provided by such a consultant. Accordingly, prudent plan sponsors will choose to work with only those retirement plan consultants who are fiduciaries, and who acknowledge such fiduciary obligations in writing. See: What the 8 pillars of a FINRA-replacing entity for RIA oversight look like and how personal accountability is key.

Of course, some plan sponsors might feel (as they are often very successful businesspeople) that they can evaluate the offerings of any retirement plan consultant themselves. But do they really possess that knowledge? It’s not just knowledge of mutual fund share classes; it is also the knowledge of the fees and costs of mutual funds that are not included in the annual expense ratio. These include fees and costs relating to transactions within the mutual fund, including brokerage commissions (including but not limited to insidious soft-dollar payments), bid-ask spreads and principal mark-ups and mark-downs, market impact, and opportunity costs for delayed or canceled trades. Opportunity costs due to the presence of cash within a fund also exist. Securities-lending revenue may also exist, which may enhance a fund’s returns, but often inappropriate (in my view) sharing of securities-lending revenue occurs with the investment advisor.

Moreover, even those fees which are part of the annual expense ratio should be assessed carefully. As I have written before, 12(b)-1 fees of any kind should be highly suspect (regardless of whether they are utilized to offset fees of service providers to the plan). The recent Tibble v. Edison International decision contains an express warning to plan sponsors that 12(b)-1 fees are likely to be heavily scrutinized, for their adverse impact upon plan participants, in future cases. See: How the new 12b(1) fee restrictions could transform the financial advisory industry.

What questions should plan sponsors be asking?

In the interim, all plan sponsors should be asking very tough questions of their “retirement plan consultants” or “advisors” — and seeking the answers in writing. The questions posed might be similar to those I have previously suggested that individual investors should ask. See “How to Choose a Financial/Investment Advisor — A Checklist for Consumers” — located at http://scholarfp.blogspot.com/2013/05/how-to-choose-financialinvestment.html.

Even then, some “fiduciary advisors” seek to disclaim or have clients waive their fiduciary obligations. And such fiduciary advisors (incorrectly, in my view) believe that they can operate however they please, as long as they disclose the existence of conflicts of interest.

Plan sponsors — be careful out there!

In conclusion, it’s a minefield of potential liability for plan sponsors.

Some relief, in the form of the DOL’s new definition of “fiduciary,”, may be coming. But the rule-making process will likely take a year or more (if the rule gets enacted at all, given the huge opposition from Wall Street and the insurance companies).

In the interim, plan sponsors should, in my view, only engage only those retirement plan consultants who are willing to accept full fiduciary status, in writing. Such consultants should not receive any other material compensation, from any third party (that means no 12(b)-1 fees, no payment for shelf space, no soft dollar compensation and no gifts or trips). Tough questions should be asked, and the answers obtained in writing.

Share your thoughts and opinions with the author or other readers.


Stephen Winks said:

August 19, 2013 — 11:40 PM UTC

Indeed plan sponsors beware. If the brokerage industry and product vendors are not responsive to the needs of the plan sponsor who is held to a fiduciary standard of care on behalf of their employees, then could there not be a better case for RIAs to fill the leadership vacuum in support of professional standing the plan sponsor demands?

Large scale institutionalized support for fiduciary standing is more likely going to come from very large RIAs like CapTrust or New England Pension Counsel which advise well over $100 billion in assets. This level of expert fiduciary counsel can not be replicated in a brokerage format regardless the size of the broker/dealer.

Disaffected brokers who seek professional standing may have no choice but to seek affiliation with expert counsel.


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