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Hughes v Northwestern: What is a "Prudent" 401(k) Investment?

Eric Droblyen

on February 2nd, 2022

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Last week, the Supreme Court of the United States (SCOTUS) issued their highly-anticipated Hughes v. Northwestern University decision. In a unanimous opinion, the court reaffirmed – as articulated in Tibble v. Edison International – that 401(k) fiduciaries have an obligation under ERISA to continuously “monitor” their plan’s investment menu and to remove any imprudent investments timely. A lower court - the 7th U.S. Circuit Court of Appeals - had dismissed case in 2020, suggesting that 401(k) fiduciaries could shield themselves from claims of imprudent investment selection by offering a diverse investment menu. SCOTUS returned the case to the 7th Circuit for reconsideration.

I’m happy with the SCOTUS ruling. I was worried the 7th Circuit decision could lead to 401(k) fiduciaries bloating their plan’s investment menu in an attempt to sidestep their monitoring responsibility. The Northwestern plan had 400+ investments!

That said, I’m disappointed SCOTUS didn’t outline a prudent process for monitoring 401(k) investments in their opinion. ERISA does not define a “prudent” investment today. I think that omission is a big reason why imprudent investment selection is one of the top three reasons why 401(k) fiduciaries are sued today.

My definition of a “prudent” 401(k) investment? A fund that meets its investment objective for reasonable fees. I have never seen an index fund from leading providers such as Vanguard, Fidelity, or Schwab fail to meet this definition. Here’s the process I use to select and monitor a menu of “prudent” index funds.

High 401(k) Fees

Step 1 - Establish an Investment Policy

To guide the selection of their 401(k) investments, plan fiduciaries should establish an investment policy. Given the straightforward investment objective of index funds (market-correlated returns), I think a basic policy (written or not) with the following objectives can suffice:

  1. Diversification – the investment menu must offer different, internally-diversified options with materially different risk and return characteristics.
  2. Market returns – each investment option must deliver returns that closely correlate to a target market benchmark over time.
  3. Efficiency – each investment option must have reasonable fees (i.e., be cost-efficient) to help participants avoid unnecessary investment losses.

Step 2 - Select Funds that Meet the Investment Policy

To satisfy the objectives of their investment policy, 401(k) plan fiduciaries should select index funds that meet the following requirements:

  1. Diversification – to satisfy this objective, plan fiduciaries should select enough index funds to meet the diversification requirements of ERISA section 404(c). This requirement can be met by offering as few as three investments that cover equity (stocks), fixed income (bonds), and capital preservation asset classes. Index funds that track a broad market are internally diversified.
  2. Market Returns – to satisfy this objective, plan fiduciaries should select index funds that deliver market-correlated returns. To determine whether a fund meets this criteria, I evaluate the fund’s R-Squared and Beta
    1. R-squared - measures how closely a fund’s performance can be attributed to the performance of its benchmark. I target a R-squared between 0.90-1.00.
    2. Beta - measures a fund’s volatility compared to its benchmark. I target a beta between 0.90-1.10.
  3. Efficiency – to satisfy this objective, plan fiduciaries should select index funds that rank in the lowest quintile (20th percentile) of their peer group in terms of expenses.

Below is an all-Vanguard investment menu that would meet these requirements (based on September 30, 2021 data).

Name

Symbol

Benchmark

Beta(1)

R2(1)

Exp Ratio

Rank(2)

Vanguard Total Bond Market Index Fund

VBTLX

BloomBarc U.S. Aggregate Float Adjusted Bond Index

1.00

0.99

0.05%

Lowest Quintile

Vanguard 500 Index Fund

VFIAX

Standard & Poor's 500 Index

1.00

1.00

0.04%

Lowest Quintile

Vanguard Extended Market Index Fund

VEXAX

Standard & Poor's Completion Index

1.00

1.00

0.06%

Lowest Quintile

Vanguard Total International Stock Index Fund

VTIAX

FTSE Global All Cap ex US Index

1.00

0.99

0.11%

Lowest Quintile

Vanguard Inflation-Protected Securities Fund

VAIPX

BloomBarc U.S. Treasury Inflation Protected Index

0.94

0.98

0.10%

Lowest Quintile

Vanguard Total Stock Market Index Fund

VTSAX

CRSP U.S. Total Market Index

1.00

1.00

0.04%

Lowest Quintile

Vanguard Total International Bond Index Fund

VTABX

BloomBarc Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged)

1.01

1.00

0.11%

Lowest Quintile

Vanguard Growth Index Fund

VIGAX

CRSP U.S. Large Cap Growth Index

1.00

1.00

0.05%

Lowest Quintile

Vanguard Value Index Fund

VVIAX

CRSP U.S. Large Cap Value Index

1.00

1.00

0.05%

Lowest Quintile

Vanguard Federal Money Market Fund(3)

VMFXX

US Gov't Money Market Funds Average

N/A

N/A

Not Rated

N/A

(1)Based on trailing 36-month fund returns relative to the associated benchmarks.

(2)From Morningstar

(3)Not an index fund, but necessary to meet the diversification requirements of ERISA section 404(c).

Step 3 – Monitor the Investment Menu Periodically

Once 401(k) fiduciaries select an investment menu for their plan, they can’t simply assume the investments will be prudent forever – they must monitor the investments periodically. To do so, fiduciaries should repeat the process they used to select investments in the first place.

How often should this monitoring occur? That’s a good question that I hope the courts will answer. I would say quarterly to be conservative.

When are Active Fund a Prudent 401(k) Investment?

In my view, an active fund must outperform “comparable” index funds (i.e., index funds that target the same market benchmark) to be a prudent 401(k) investment.

According to studies like the Morningstar Active/Passive Barometer and the SPIVA Scorecard, most active funds fail to do so over the long-term, net of fees.

Index Funds Should be the Baseline for 401(k) Investment Returns!

It can be tough to beat the returns of leading index funds. Another benefit of these funds for 401(k) fiduciaries? They offer easy monitoring given their straightforward investment objective (market-correlated returns) and low fees.

I hope the court that ultimately decides the Hughes v. Northwestern University case makes index funds the baseline for 401(k) investment returns. In my view, 401(k) plan participants should earn no less.

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