401k Investors’ Right to “Sufficient Information to Make an Informed Decision”

Watching the recent sell-off in the markets and the reported trillion dollar daily losses for investors, I cannot help but wonder how much of those losses were preventable, especially for 401k investors. 401k plans are increasingly opting for participant directed retirement plans that shift the risk and burden of retirement investing on the plan participants. Even though ERISA permits plan sponsors to provide investment education programs for plan participants, there is increasing concern among plan sponsors and others that participants may not be able to effectively manage their retirement accounts.

As you review ERISA and other applicable retirement plan related legislation, you notice three persistent themes, or duties, for fiduciaries: prudence, diversification and the avoidance of large losses. In discussing these duties, modern portfolio theory is constantly mentioned as the standard in assessing compliance with these duties.

Dr. Harry Markowitz introduced the concept of Modern Portfolio Theory (MPT) in 1952. Prior to MPT, most portfolios were constructed based purely on risk and return data. With MPT, Markowitz introduced the concept of including the correlation of returns of available investment options as a factor in constructing investment portfolios. By factoring in the correlation of returns, an investor can combine investments that behave differently in various market conditions, which theoretically reduces the overall volatility of the investment portfolio. While MPT’s calculations have been the subject of legitimate criticism, the benefit of combining assets with low correlations of return is still valid. Both the Department of Labor and the courts still point to the principles of modern portfolio theory as the applicable standard for assessing the prudence of actions taken under ERISA.

And yet, based upon my experience, most retirement plans do not provide retirement plan participants with correlation of returns information to help them make informed investment decisions. Participants are generally only provided with information regarding an investment’s annual returns and standard deviation. As a result, plan participants often end up with portfolios that are not effectively diversified, leaving the participant needlessly exposed to investment risk.

Plan participants are often offered various investment options, with funds described as large cap, small cap, growth, value, international, and emerging. Without correlation of returns information, a plan participant often constructs a portfolio seemingly diversified based purely upon the number of funds and the difference in names of their investments. Investors are therefore lulled into a false sense of security by this “pseudo” diversification.

Without correlation of returns information on the plan’s available investment options, plan participants are unaware that many of their investment choices behave similarly in different market conditions, thereby providing little if any protection against downturns in the market. Studies have consistently shown an increase in the correlation of returns of equity based investments of all kinds, including international equity investment products. Furthermore, studies have shown that over the past decade, the correlation of returns among equity based investments has increased even more during periods of volatility in the market, effectively reducing the perceived benefits of diversification.

Most 401k plans have chosen to adopt participant directed plans under Section 404(c) of ERISA. One of the requirements for qualifying under 404(c) is that the plan sponsor provide plan participants with “sufficient information to make an informed decision” regarding the plan’s available investment options. Given the fact that ERISA, the Department of Labor and the courts have recognized MPT as the applicable standard for prudence with regard to retirement plans, and that the cornerstone of MPT is using correlation of returns in the portfolio construction process, one can legitimately question whether a retirement plan’s failure to provide plan participants with correlation of returns information for a plan’s investment options allows a plan participant to make an informed decision as required under the law. Furthermore, a question arises as to whether the failure to provide such information constitutes a breach of fiduciary duty by the retirement plan’s named fiduciary.

I believe that these are questions that are soon to be presented given the LaRue decision, which established the right of plan participants to bring personal actions for losses incurred in their retirement accounts, and the investment losses that plan participants are suffering. While many retirement plans offer some sort of investment education programs, my experience has been that such programs are usually provided by companies that are serving as service providers to a plan and are seriously lacking in meaningful content.

The typical education programs that I see consists of a number of multi-color pie charts and simplistic recommendations such as to select an asset allocation and never change that allocation, except for an occasional re-balancing to the original allocation. This “buy-and- hold” approach, sometimes referred to as the “buy, forget and regret” approach to investing, completely ignores the cyclical nature of the market and is contrary to the standards for prudent investing established by the Restatement of Trusts (Third) Prudent Investor Act. Investors would be better served to follow the advice of Chinese philosopher Lao Tzu, who advised that “the best way to manage anything is by making use of its nature.”

I have yet to come across one retirement plan educational program that discloses the correlation of returns data for a plan’s actual investment options or addresses the use of such data in constructing an effectively diversified investment portfolio, even though there is no legal prohibition from providing such information. In fact, ERISA Section 404(c) and Department of Labor Interpretive Bulletin 96-1 clearly support disclosure of such information.

Plan participants are legally entitled to information that allows them to make informed decisions, to protect their financial security. Correlation of returns data provides valuable information to plan participants as it allows them to effectively diversify their investment portfolios in order to prevent large losses. Court decisions have indicated that the failure to provide such information to plan participants raises questions as to whether a participant can truly exercise control over their retirement account, which is one of the requirements for a 404(c) plan.

Plan participants should request up-to-date correlation of returns data annually for every investment option offered in their retirement plans. A refusal by a plan’s sponsor to provide such information should be noted and the plan participant should seek such information from an independent investment adviser in order to properly protect their financial security. My feelings, warnings and advice with regard to the typical retirement plan educational programs can best be summed up by points eight and twelve at http://bit.ly/4zkE5k.

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One Response to 401k Investors’ Right to “Sufficient Information to Make an Informed Decision”

  1. Ron Surz says:

    Education definitely needs to be stepped up for participant-directed investments, but let’s not lose sight of employer-directed investments, namely default investments such as target date funds. Employers are not taking their responsibility seriously, choosing to believe that any QDIA will do. It will take take court decisions to wake up fiduciaries to the fact that they are liable, but why take the risk in the meantime?

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