3 Things Every 401(k) Participant and Plan Sponsor Should Know – 2017

As a wealth preservation attorney, one of the primary issues I address is the quality of a client’s investment portfolio. Far too often I see excellent estate planning strategies sabotaged by horribly unsuitable investment portfolios. Since many estate planning strategies are dependent on revenue from an investor’s 401(k) or other investment portfolio, it is critical that an investor’s portfolios are properly invested and managed.

Based upon my 30+ years of experience in the areas of fiduciary law and quality of investment advice, there are three key issues that I tell clients, both individuals and 410(k) plans, to key on.

  1. Most 401(k) plans mistakenly believe that they are compliant with ERISA’s rules and regulations. In a survey of 401(k) plan, 94 percent of the plans indicated that they felt they were compliant with ERISA. Compare that to the opinion of Fred Reish, one of the nation’s most respected ERISA attorneys, who has stated

[O]ur experience is that very few plans actually comply with 404(c). It is probable that most (perhaps as high as 90%) 401(k) plans do not comply with 404(c) and, as a result, the fiduciaries of those plans are personally responsible for the prudence of the investment decisions made by participants.(1)

While there are a variety of reasons why a 401(k) plan may be non-compliant, in my practice I focus on quality of investment advice/options issues since that is the area where I have extensive experience, having served a director of compliance for some broker-dealers and director of financial planning quality assurance for AXA Advisors. Which leads to my second point:

2. Most 401(k) plans use inadequate methods in selecting and monitoring the investment options in their plans. To be perfectly honest, based on my experience as an ERISA/securities attorney and consultant, many 401(k) plans blindly follow the advice of their service providers, even though numerous court decisions have warned that doing so is not only improper, but constitutes a breach of their fiduciary duties to the plan and its participants.

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.(2)

The failure to make any independent investigation and evaluation of a potential plan investment is a breach of fiduciary obligations….(3)

Most plans analyze potential investment options by only looking at an investment’s investment performance and its standard deviation. However, as everyone knows, past performance is no guarantee of future returns. Secondly, an investment’s fees and other expenses must be considered since each additional 1 percent in fees and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period. Given the fees and costs associated with some investments, an investor could easily see his end return by one-third or one-half.

Noted investment expert Charles Ellis has noted the impact of fees on an investor’s end return. With the availability of low-cost index mutual funds, Ellis has suggested a simple, more effective way to evaluate expensive, yet often underperforming,  actively managed mutual funds.

[T]he incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fee for a comparable index relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high – on average, over 100 percent incremental returns!(4)

That’s right: All the value added – plus more – goes to the manager, and there’s nothing left over for the investors who put up all the money and took all the risks.(5)

Anyone who takes the time to use my simple proprietary metric, the Active Management Value Ratio 2.0™ (AMVR), can verify the accuracy of Ellis’ and Malkiel’s statements. Details on the AMVR can be found here.

In the AMVR, we use a fund’s stated annual expense ratio and its stated turnover ratio in comparing an actively managed mutual fund a comparable index fund. We chose those two variables based on the findings of noted investment expert Burton Malkiel, namely that

The two variable that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover.(6)

Malkiel’s findings on the impact of a fund’s fees have been corroborated by similar studies.(7). The impact of fees on performance was also reinforced by a study by noted financial experts Eugene Fame and Kenneth French, who found that only the top 3 percent of active managers were able to produce returns that even covered their funds expenses.(8)

3 Many 401(k) plans are poorly constructed and therefore inefficient in terms of risk management, both in terms of plan participants and plan fiduciaries.

Effective diversification is a key element in successful wealth management, with effective being the key word. Many investors and 401(k) plan sponsors mistakenly believe that effective diversification requires nothing more than investing in a lot of different types of investments, with the number of investments providing the downside protection against large losses that diversification supposedly provides.

However, effective diversification is more than just a “quantity” of investments issue. As Nobel laureate Harry Markowitz, the father of Modern Portfolio Theory, properly points out

it is not enough to invest in many securities…To reduce risk, is is necessary to avoid a portfolio whose securities are all highly correlated with each other.

In other words, effective diversification requires putting together a portfolio consisting of investments that behave differently under various economic and market conditions, investments that “zig’ when other investments “zag.”

Many 401(k) plans elect to be designated as 404(c) plans in an attempt to shift investment risk from the plan to the plan participants. One of the key requirements to qualify as a 404(c) plan is that the plan sponsor must provide plan participants with “sufficient information to make informed investment decisions with regard to investment alternatives available under the plan.”

The courts and the Department of Labor have repeatedly stated that Modern Portfolio Theory (MPT) is the standard to be used under ERISA in determining whether a plan fiduciary acted prudently. As Markowitz’s quote states, the correlation of returns among investments is the cornerstone of MPT and effective diversification. And yet, ERISA does not explicitly require disclosure of such valuable information to plan participants.

This oversight denies plan participants the information they need to properly construct efficient plan accounts in terms of risk management, investment accounts that provide effective downside protection against significant losses. Consequently, this oversight, and the failure of plan fiduciaries to incorporate consideration of the correlation of returns factor into their required due diligence process, also leaves plans and plan fiduciaries exposed to successful breach of fiduciary duty claims.

Most 401(k)/404(c) plans still consist primarily of actively managed equity-based mutual funds. A large majority of these equity-based funds are large cap funds-large cap growth, large cap value and large cap blend funds. Over the past 10 to 15 years, these funds’ returns have shown a high correlation of returns to each other, over a 90% correlation of returns to each other. As a result, it can, and has been, successfully argued that plans dominated by these highly correlated funds do not allow plan participants to properly protect their retirement plan accounts.


The evidence clearly establishes that many 401(k)/404(c) plans are inefficient, both in terms of cost and risk management. So, what does this mean for 401(k) participants and plan sponsors, as well as investors in general. If your financial security is really important to you and your family, take the time to review the investment options within your 401(k) or other retirement plan and request that more efficient options be added.

People often tell me that they do not want to “cause any trouble,” so they just accept whatever they are given, in terms of investment options and/or investment advice. That rational is simply unacceptable, especially since the AMVR provides a means for 401(k) participants and plan sponsors, as well as any investor, to quickly and privately analyze mutual funds.

The AMVR allows investors and investment fiduciaries to be proactive and avoid those actively managed funds that actually end up costing investors due to an over-concentration in highly correlated funds, funds with a history of consistent underperformance, and/or situations where a fund’s incremental costs exceeds any incremental return the fund is able to produce. 401(k) participants and investors in general do not have to accept, and should not accept, such situations. The same applies to plan sponsors as well, especially since they can face personal liability for failing to detect and reject such imprudent situations.

This article is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.


(1) Fred Reish, “Participant Investing: Forewarned is Forearmed,” ERISA Report for Plan Sponsors,” September 2004, No. 7, No.2., available online at http://www.drinkerbiddle.com/resources/publications/2004/participant-investing-forewarned-is-forearmed?Section=FutureEvents ; Fred Reish, “Just out of Reish: A Good Defense,” PLANSPONSOR, September 2205, available online at http://www.plansponsor.com/MagazineArticle.aspx?Id=4294991584 
(2) Fink v. National Sav. and Trust Co., 772 F.2d 951, 957 (D.C.Cir 1985)  See Donovan v. Cunningham, 716 F.2d at 1467; Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981), modified on other grounds, 680 F.2d 263 (2d Cir.), cert. denied, 459 U.S. 1069, 103 S.Ct. 488, 74 L.Ed.2d 631 (1982).
(3) U.S. v. Mason Tenders Dist. Council, 909 F. Supp. 882, 887 (citing, Fink v. National Savs. & Trust Co., 772 F.2d at 957)
(4) Charles Ellis, “My Investment Letter: Words of Advice for My Grandchildren,” AAII Journal, October 2013.
(5) Charles Ellis, “Winning the Loser’s Game,” 6th ed., (New York, NY/McGraw-Hill 2018), 164.
(6) Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed., (New York, NY/W.W. Norton and Co. 2015), 401.
(7) Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, Vol LII, No. 1, (March 1997), 57-81.
(8) Eugene Fama and Kenneth French, “Luck versus Skill in the Cross Section of Mutual Fund Returns,” available online at https://www.dimensional.com/famafrenchessays/luck-versus-skill-in-mutual-fund-performance.aspx

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