The Supreme Court's Putnam Decision

ERISA Fiduciary Investment Practice and Last Month's Supreme Court Decision

Last month’s U.S. Supreme Court decision not to hear an appeal of a 1st Circuit fiduciary investment decision has been reported in trade publications as having “rattled” the 401(K) industry.

Why?

Because, regardless of final resolution to a technical legal question as to whether Plaintiff Participants or Defendant Fiduciaries have the burden of proving a breach of fiduciary duty…

                                   â€¦there may be a breach finding in this case. And then, on remand to the trial court, as explained in the Depart of Labor’s Amicus Brief, see 18-926_putnam_-_11.26.pdf, the Trial court will likely determine whether there was a resulting loss to the Plan using suitable index-fund benchmarks.

The real danger is that this determination will be made using a primitive siloed fund by fund comparison.

Even Putnam has not yet shown the court how inappropriate, primitive, and contrary to basic ERISA requirements, this siloed analysis would be. All that Putnam, and several trade groups, had asked SCOTUS to decide was whether actively managed funds that did not perform as well as index funds, and selected by the plaintiffs with the benefit of hindsight, suffice as a matter of law to establish “losses to the plan.”

 But Putnam’s investment division, on which the Plan’s fiduciary relied to select and monitor all but the Plan’s default investment funds, is a sophisticated investment manager. It never creates portfolio’s without testing the efficiency of the portfolio. This is what is so baffling about Putnam’s behavior in this case.

Putnam unquestionably had (and has) a superior ability to not only evaluate the volatility and expected returns of the Putnam funds, but to do so taking into account the correlation of these factors for each funds in relation to the other funds being used or considered.

Putnam has both the expertise and the day to day experience in selecting funds using generally accepted Modern Portfolio Theory, e.g., volatility, historical and expected (after expenses) return, as well as the correlation of each fund to all other funds in the portfolio. And this is what fiduciary investment decision making requires. [i] There is no prudent selection of a fund (e.g., an active vs. a passive fund) for a single asset class. [ii] Here is why:

  1)    Higher portfolio volatility mathematically reduces portfolio returns; and that impact increases over time; and

2)    A higher volatility fund (relative to another fund of the same general asset class) may, because of correlation characteristics relative to the rest of the portfolio, either

a.    increase portfolio volatility; or

b.    decrease portfolio volatility; and

3)    A lower volatility fund (relative to another fund of the same general asset class) may, because of correlation characteristics relative to the rest of the portfolio, either

a.    increase portfolio volatility; or

b.    decrease portfolio volatility.

Accordingly, portfolio volatility and portfolio expected return, will be more or less than the arithmetic sum of individual fund volatility and fund expected return.

There is zero basis for a court to determine, using a siloed fund by fund comparison, that any particular active fund used by Putnam’s investment manager was superior or inferior to a passive index fund of the same general asset class.

Herbert A. Whitehouse February 1, 2020

[i] C.f., 29 C.F.R. § 2550.404c-1(b)(3)(i) (“…available investment alternatives [must be] sufficient to provide the participant [ ] with a reasonable opportunity to: (A) Materially affect the potential return ... and the degree of risk to which such amounts are subject; (B) Choose from at least three investment alternatives: (1) Each of which is diversified; (2) Each of which has materially different risk and return characteristics; (3) Which in the aggregate enable the participant [ ] by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant [ ]; and (4) Each of which when combined with [ ] the other alternatives tends to minimize through diversification the overall risk of a participant's [ ] portfolio…”).

[ii] The fn above is fn 32 in an article that provides a more complete context for fiduciary considerations in the selection and monitoring of defined contribution investment options; viz., Whitehouse, Herbert A., The Use of ERISA § 3(38) Investment Managers in Plans Offering Mutual Fund Investment Options to Participants (April 15, 2011). NEW YORK UNIVERSITY REVIEW OF EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION - 2007, LexisNexis Matthew Bender, 2007. Available at SSRN: https://ssrn.com/abstract=1811085