A Simple Step to Better Protect Pension Plan Participants

Reviewing the reported trillion dollar losses that investors suffered during the 2000-2002 and 2008 bear markets, 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 by retirement plan fiduciaries.

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 factoring in the 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.

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 against providing such information. In fact, Section 404(c) and Department of Labor Interpretive Bulletin 96-1 clearly support disclosure of such information.

The integration of ERISA with the widely accepted principles of modern portfolio theory has resulted in a curious paradox for both retirement plan fiduciaries and investors, one with potentially serious liability implications. Plan participants are legally entitled to information that allows them to make informed decisions, to protect their financial security. 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.

Another factor supporting the disclosure of such information is the relative ease in obtaining such information.  The actual calculation of correlation of returns can be easily done by using the correlation function on Microsoft Excel. A number of sites such as Vanguard’s Advisor site and Blackrock’s iShares site provide programs that compute correlation of returns data.

There have been studies suggesting that only one-third of 404(c) plans are in compliance with the section’s requirements. One prominent ERISA attorney, with over thirty years of experience, has stated that his firm has never found a plan in complete compliance with all of 404(c)’s requirements.

The issue involving correlation of returns information seems easy enough to remedy, since the fiduciary arguably needs such information to prudently select the proper investment options for the plan. Hopefully, plan fiduciaries will begin to provide plan participants with such information in order to protect plan participants against unnecessary risk exposure due to “pseudo” diversification and to protect themselves from unnecessary liability risk exposure.

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