The Supreme Court’s decision in LaRue v. DeWolff, Boberg & Associates(1) in 2008 started a trend recognizing the need for greater protection of participants in defined contribution pension plans. The LaRue decision signaled the long overdue recognition by the judicial branch that, unlike defined benefit pension plans, defined contribution plans shift investment risk to the plan’s participants and beneficiaries.
Recent cases such as Braden(2), Tibble(3) and Tussey(4) have continued the trend in protecting plan participants. Recent participant-centric cases have focused on the issue of unnecessary costs associated with a plan’s investment options. While this is an important issue, this paper focuses on yet another issue which should be pursued, that being the fact that key promises provided by ERISA, namely the promises of a “broad range” of investment options and “sufficient information to make informed investment decisions,” are not being kept.
ERISA’s Promise of Disclosure
In discussing the importance of disclosing investment information to 401(k) participants, the preamble to the final 404(c) regulations (“Preamble”) stressed the need
to ensure that participants and beneficiaries in ERISA section 404(c) plans have sufficient information to make informed investment decisions….[as] the investment decisions made by participants and beneficiaries in ERISA 404(c) plans will directly affect the funds available to such individuals at retirement. For this reason, participants and beneficiaries should be assured of having access to that information necessary to make meaningful investment decisions.(5)
However, ERISA has totally failed to ensure that participants and beneficiaries actually receive such meaningful investment information. As a result, participants and beneficiaries in 401(k) and 404(c) suffered significant losses in the 2000 and 2008 bear markets, losses which could have been reduced had plan participants actually had the information necessary to implement strategies to reduce or avoid such losses.
Modern Portfolio Theory and 401(k)/404(c) Plans
Defined contribution pension plans have emerged as the primary form of private pension plans. The popularity of 401(k) plans lies in the fact that defined contribution plans allow employers to shift the burden and risk of investment loss to the plan participants by electing so-called 404(c) status. If a plan meets all of the requirements for 404(c) status, then a plan is not responsible for any losses incurred as a result of a participant’s investment choices.(6)
In reviewing both the statute and relevant regulations governing 401(k) plans, the language clearly references the applicable principles of modern portfolio theory, especially the importance of effectively diversifying one’s investment portfolio. The ERISA fiduciary is required to give
appropriate consideration to those facts and circumstances, given the scope of such fiduciary’s investment duties, the fiduciary knows or should know, are relevant to the particular investment or investment course of action, including the role that the investment plays in the plan’s investment portfolio, and has acted accordingly.(emphasis added)(7)
Appropriate consideration by a fiduciary requires him to determine that an investment is reasonably designed, as part of the plan’s portfolio, to further the purposes of the plan, taking into consideration the risk of loss, the opportunity for gain, the extent of the portfolio’s diversification, the portfolio’s liquidity and the investment’s projected return.(8)
Modern Portfolio Theory (MPT) was introduced in 1952 by Dr. Harry Markowitz.(9) The cornerstone of MPT was the introduction of the correlation of returns among investments as a factor in creating investment portfolios. Prior to the introduction of MPT, portfolios were constructed largely using only an investment’s returns and standard deviation. The theory behind including MPT in the portfolio process was to combine investments that behaved differently in various economic conditions in order to avoid large losses.
While Markowitz’s concept of MPT has been fairly criticized due to the questionable assumptions behind the theory and its calculation process, the validity in factoring in correlation of returns among investments remains a valid and valuable approach to portfolio construction and risk management. Both the Department of Labor (DOL) and the courts have adopted modern portfolio theory, and the value of effective diversification, as the standard in evaluating the prudence of ERISA fiduciaries’ actions.(10)
The cornerstone of modern portfolio theory is diversification based on the correlation of returns among the investments being considered. Therefore, it can be argued that plan sponsors must factor in correlations of returns of the investments chosen for their plan in order to ensure ERISA’s promise of a “broad range” of investment options. Likewise, it can be argued that plan participants should be given the same information in order to exercise the same prudence with their own plan accounts.
Diversification and Risk Management
Proper risk management through the use of effective diversification depends on using the correlation of returns of investment. As Markowitz stated in his seminal book, “Portfolio Selection: Efficient Diversification of Investments,”
To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in unison afford little protection than the uncertain return of a single security(11)
Markowitz’s position on effective diversification has been adopted by the Restatement (Third) Trusts.(12) And yet, courts and various commentators, while admitting the values of effective diversification, often continue to analyze diversification solely on the basis of the number of investment options offered by a pension plan.
There is a popular investment saying that says that “amateurs chase returns, while professionals manage risk.” That sentiment is seconded by two legends in investment management, Ben Graham and Charles Ellis, to wit:
The essence of investment management is the management of risk, not the management of returns.(13)
Managing market risk is the primary objective of investment management.(14)
Factoring in the correlation of returns of various investments allows investors, including plan sponsors and plan participants, to manage risk by avoiding a portfolio made up entirely or largely of highly correlated investments. It also allows investors to avoid being confused by the “diversification by asset category” scam often perpetrated by dishonest and unethical plan service providers and other financial advisers, a scam which leaves unsuspecting investors without the benefits of effective diversification, particularly downside risk protection.
ERISA’s “Broad Range” and “Sufficient Information” Promises
ERISA section 404(c) sets out various requirements that must be met in order for a plan to effectively shift the risk of investment losses to the plan’s participants. One of the sections main requirements is that a plan provide its participants with a “broad range” of investment options.(15) Section 404(c) requires that a plan offer at least three types of diversified investment options-a broad equity-based investment option, a broad fixed income-based investment option, and a cash/money market based investment option.(16) Each category of investment option offered by a plan must have materially different risk and return characteristics.(17)
The other main 404(c) requirement is that the plan must provide participants with “sufficient information in order to make informed investment decisions” in order to allow participants to minimize the risk of large investment losses.(18) The courts have recognized the importance of ERISA’s promise of “sufficient information.” As one court noted
courts must look to the evidence and determine whether the plan provided the participants ample information, including adequate information to understand and evaluate the risks and consequences of alternative investment options.(19)
Building on the importance of the provision of “sufficient information,” at least two courts have suggested that if participants are not provided with the material information necessary to protect their interests, then the participants cannot be said to have exercised the control over their 404(c) account as required by ERISA for 404(c) status.(20)
Section 404(c) incorporates the information disclosure requirements of 401(k) plans. Sadly, neither requires the disclosure of correlation of returns data for the investment options offered by the plan.
The DOL has released a bulletin outlining various types of investment information that may be provided to plan participants without incurring any additional fiduciary liability. Interestingly enough, the bulletin states that plan sponsors can provide generic information on general investment topics such as historical investment returns, historical investment risk and correlation of returns.(21)
So the DOL says plans can educate plan participants on the importance and benefits of correlation of returns information, but they do not allow plans to provide plan participants with the correlation of returns data for the plan’s actual investment options, thereby denying participants the opportunity to effectively diversify their retirement accounts and minimize the risk of large losses. This would seem to be totally inconsistent with ERISA’s stated purpose, to help protect pension plan participants and their beneficiaries.(22)
It can, and should, be argued that correlation of return data is analogous to the historic return and risk data allowed under the DOL’s release, as such data does not advise plan participants as to which investments to choose. Correlation of returns data simply gives investors material information on which investments not to choose in order to minimize their investment risk. This would seem to be totally consistent with both ERISA’s promise of “sufficient information” to allow “meaningful control over the assets in their account, as well as ERISA’s stated purpose to help protect pension plan participants and their beneficiaries.
Time For Change
404(c) is not working. It does not provide participants with the information they need to make informed and reasoned investment decisions.(23)
That was the testimony of Fred Reish, one of the nation’s leading ERISA attorney, before the Department of Labor’s Advisory Council. Mr. Reish was simply stating what many ERISA experts already know, especially with regard to information needed by plan participants to implement effective risk management strategies.
Fiduciary law is derived from the common law of trusts and agency. Both trust law and agency law emphasize the importance of a fiduciary’s duty of loyalty, which includes a duty to disclose material information to a fiduciary’s beneficiaries and principals, especially when silence may result in harm to such beneficiaries and principals.(24) Under ERISA, a plan sponsor is a fiduciary.
Given the obvious significance of correlation or returns data in the risk management process and ERISA’s admitted goal of providing plan participants with “sufficient information to make informed decisions” to effectively manage their retirement accounts and avoid large losses, one would wonder why the DOL does not seek a change to require the disclosure of such data to plan participants. When this issue is brought up, opponents often claim that plan participants would not understand the data and/or would not know how to properly use such data.
That objection is an education issue and has nothing to do with the value of such information protecting plan participants and in furthering ERISA’s goals. Sadly, ERISA does not require plans to provide education to plan participants. The ability of 404(c) plans to transfer investment risk to plan participants, without requiring both the disclosure with such material information and education program on how to properly use such information, effectively allows plans and plan sponsors to throw 404(c) plan participants “under the bus.”
It has been suggested that the failure to provide investment education to plan participants could be deemed to be a breach of the plan sponsor’s fiduciary duty of loyalty to the plan participants.(25) This argument is even more persuasive given the Securities and Exchange Commission’s recent study which concluded that most Americans are functionally illiterate with regard to investing.(26)
The real resistance to providing correlation of return information to plan participants, and for that matter plan sponsors, could be that disclosure of such information would reveal a conflict of interest between plan service providers and pension plans. Forensic analyses of pension plans often show that the majority of investments recommended by plan service providers, especially with regard to equity-based investments, are highly correlated and, therefore, are not compliant with ERISA’s “broad range” requirement. This can result in unwanted potential liability for plan sponsors and improper risk exposure for plan participants, as they cannot effectively diversify their plan accounts.
The denial of such material information is both unnecessary and inequitable given a 404(c) plan’s ability to shift the risk of investing onto the plan’s participants. Both Congress and the DOL need to amend ERISA by requiring that plan participants and their beneficiaries be provided with correlation of returns data on the investments offered by their 401(k) and 404(c) plans, as well as educated on the proper usage of said data so they can properly manage their plan accounts to minimize the risk of large losses.
1. LaRue v. DeWolff, Boberg & Associates, 128 S.Ct. 1020 (2008)
2. Braden v. Wal-Mart Stores, Inc , 588 F.3d 585 (8th Cir. 2009)
3. Tibble v. Edison International, 711 F.3d 1061 (9th Cir. 2013)
4. Tussey v. ABB, Inc., 54 WL 1113921 (W.D. Mo., March 31, 2012)
5. Preamble to 404(c) Final Regulations, 57 Fed. Reg. 46906, 46909-46910
6. 29 C.F.R. § 2550.404c-1(d)(2)(i)
7. 29 C.F.R. § 2550.404a-1(b)(1)
8. 29 C.F.R. § 2550.404a-1(b)(2)
9. Harry M. Markowitz, Portfolio Selection: Efficient Diversification of Investments”, 2d ed., (Malden, MA: Basil Blackwell Publishers, Inc., 1991)
10. DiFelice v. U.S. Airways, Inc., 497 F.3d 410, 423 (4th Cir. 2007); Laborer’s Nat’l Pension Fund v. N. Trust Quantitative Advisors, Inc., 173 F.3d 313, 317 (5th Cir. 1999)
11. Markowitz, 5
12. Restatement Third, Trusts, § 90 (Prudent Investor Rule), cmt f. Copyright © 2007 by The American Law Institute. Reprinted with permission. All rights reserved. (“Effective diversification, then, depends not only on the number of investments but also on the ways and degrees in which their responses to economic events tend to cancel or neutralize one another through negative or slight ‘covariance’.”)
13. Ben Graham quote
14. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th ed. (New York, NY: McGraw/Hill 2010), 103-104
15. 29 C.F.R. §2550.404c-1(b)(1)(ii)
16 .29 C.F.R. §2550.404c-1(b)(3)(i)(B)
17. 29 C.F.R. §2550.404c-1(b)(3)(i)(B)(2)
18. 29 §2550.404c-1(b)(2)(i)(B)
20. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010); In re Sprint Corp. ERISA Litigation, 388 F. Supp. 2d 1207 (D. Kansas 2004)
21. Department of Labor Interpretive Bulletin 96-1
22. 29 U.S.C. § 1001(b); In re Unisys Sav. Plan Litigation, 74 F.3d 420, 434 (3d Cir. 1996)
23. Available online at http://www.drinkerbiddle.com/publications/ Detail.aspx?pub=2592
24. Restatement Third, Trusts, § 78. Copyright © 2007 by The American Law Institute. Reprinted with permission. All rights reserved. (“Whether acting in a fiduciary capacity or personal capacity, a trustee has a duty in dealing with a beneficiary to deal fairly and to communicate to the beneficiary all material facts the trustee knows or should know in connection with the matter.” (emphasis added)
26. Ary Rosenbaum, “Why 404(k) Plan Sponsors Should Make Sure Education and Advice is Offered to Their Participants,” http://www.jdsupra.com/legalnews/why-401k-plan-sponsors-should-make-sur-30437/
27. “Study Regarding Financial Illiteracy Among Investors,” available online at http://www.sec.gov/ news/studies/2012/917-financial-literacy-study-part1.pdf