Short answer – probably.

Fred Reish, one of the nation’s most respected ERISA attorneys, has publicly testified that few 401k /404c plans are in full compliance with ERISA’s applicable requirement. Failure to comply with ERISA’s requirements means that the plan and its officers and fiduciaries are liable for any and all losses suffered by the plan participants.

Given my securities compliance background, I am more interested in the investment related liability aspects of 401k /404c plans. The growing number of cases involving 401k /404c investment related claims, and the number of multi-million dollar settlements of such claims, indicates genuine and serious problems within these plans. These problems generally result in liability exposure for plans, plan sponsors and other plan fiduciaries.

Most of the current legal actions involving 401k /404c plans are focusing on the issue of excessive fees. Not all such legal actions have resulted in decisions or settlements in favor of plan participants. However, I submit that had the courts or the arbitrators correctly analyzed the fees in question, plan participants should have prevailed in all of their actions.

The primary problem with the current analysis of investment options offered by a 401k /404c plan is that they only look at the absolute, or stated, fee. However, the stated fee can be extremely misleading, especially if ERISA’s stated goal of protecting plan participants and their beneficiaries, including the avoidance of unnecessary and excessive fees, is controlling.

In his classic book, “Winning the Loser’s Game,” Charles Ellis suggested that the proper way to assess the prudence of an investment is to evaluate the investment’s incremental fees in terms of the investment’s incremental returns. By focusing on incremental costs and returns, an investor can gain a better evaluation of the added value, if any, provided by active management.

I have previously written posts about the Active Management Value Ratio™ (AMVR), a proprietary metric that uses an investment’s incremental costs and returns to evaluate the cost efficiency of an actively managed mutual fund. Assume two funds: Fund A is an actively managed mutual fund with a five-year annualized return of 22 percent and a stated annual expense ratio of 1 percent; Fund B is an index fund with a five-year annualized return of 20 percent and an annual expense ratio of 0.22.

Fund A’s incremental cost would be 0.78 (1.00 – 0.22) and its incremental return would be 2.00 (22.00 – 20.00). Fund A’s AMVR score would be 39 (0.78/2.00), indicating an effective fee of 39 percent for the active management component of Fund A. The effective fee for Fund A would actually be 39.22 percent (39 + 0.22), hardly prudent. Another way of looking at Fund A’s fees would be that 78 percent of the fund’s total fee is only producing 9 percent of the fund’s total return. Again, hardly prudent and definitely not in consistent with ERISA’s charge to avoid unnecessary and excessive fees.

Another way of evaluating an actively managed fund’s annual fee is by using Professor Ross Miller’s Active Expense Ratio (AER). The AER compares the active component of a fund with the incremental costs of the fund to calculate a fund’s effective annual expense ratio. In our example, if we assume that Fund A has an R-squared rating of 95, then Fund A’s AER, its effective annual expense ratio, would be 4.18 percent, significantly higher than the fund’s stated annual expense ratio of 1 percent.

ERISA’s stated purpose is to protect plan participants and their beneficiaries, especially against unnecessary and excessive fees. Plan sponsors and the courts need to properly assess the annual fees of the various investment options within a 401k /404c plan by assessing the effective impact of such fees rather than by simply accepting an investment’s stated fee. Only then can plan participants interests be truly protected.

To learn more about James Watkins, visit CommonSense InvestSense.