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

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 7^th Circuit for reconsideration.

I’m happy with the SCOTUS ruling. I was worried the 7^th 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.

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).