Best Interest and Best Practices #12: What Does Best Interest Mean . . . In the Real World? (part 4)
This is the 12th of a new series of articles titled “The Bests.” The series focuses on Best Interest and Best Practices. Those topics give me flexibility to discuss a range of subjects that affect both service providers, including advisors, and plan sponsors, including 401(k) and 403(b) committees.
In my last three posts (#9 and #10 and #11), I discuss the Best Interest standard of care and its practical application. This article discusses a novel approach for compliance with the fiduciary standard for the selection of investments for 401(k) plans. All the more interesting, the approach was part of an opinion of the U.S. First Circuit Court of Appeals.
In October 2018, the First Circuit considered an appeal of a 401(k) case where Putnam Investments, and its fiduciaries, were the defendants. At one point, the defendants argued that, if the court found fiduciary liability under the facts of the case, it would discourage employers from adopting 401(k) plans. The Court of Appeals responded by saying:
“While Putnam warns of putative ERISA plans foregone for fear of litigation risk, it points to no evidence that employers in, for example, the Fourth, Fifth, and Eighth Circuits [which found that similar facts could result in liability], are less likely to adopt ERISA plans.”
The opinion went on to describe a “safe harbor” from fiduciary liability:
“Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these acts are not matters concerning which ERISA fiduciaries should cry ‘wolf.’”
I think it goes without saying that the court’s language was gratuitous . . . and it is a bit disturbing for judges to give investment advice.
Nonetheless, there is a point to be made. That is, at least from this Court’s perspective, the starting point is to consider index funds. Then, plan fiduciaries should seek to identify other funds, including actively managed funds, that can reasonably be expected to match or outperform the index funds. (Note that I say index funds, rather than indexes. That’s because an index fund, subject to its expense ratio, is the investable version of an index.)
In some ways, this is not different from what is commonly done. Based on my participation as a lawyer in plan committee meetings, the investment reports that advisors give to plan committees typically compare the plans’ mutual funds to appropriate indices. And, if there is sustained underperformance vis-a-vis the index, the advisors usually recommend that a fund be removed.
However, it is more complicated than that. For example, other factors can be considered, such as volatility. A less volatile investment may be more appropriate for a retirement plan and particularly for a plan covering employees who aren’t experienced investors. Also, a particular index may not be an appropriate benchmark for certain mutual funds.
In the final analysis, the issue is whether a plan committee engaged in a prudent process to select the investments; it is not whether the process predicted the best future outcome. Nonetheless, the process must have an intended outcome, and it is not unreasonable to conclude that one objective of the process is to select investments that are anticipated to outperform a comparable index fund.
Advisors and plan sponsors shouldn’t be fearful of selecting actively managed funds where there is a reasonable basis to believe that the performance of those funds will, over time, equal or exceed that of comparable index funds. So long as the process is prudent, the fiduciaries will have satisfied their legal responsibilities.
The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.