7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 1st Deadly Sin – “Income Matters”

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Envy (in the ecclesiastical world) – A willingness to subordinate one’s own needs by showing compassion for the needs of one’s neighbors is an admirable trait. This, of course, requires one to measure in some way the standing of one’s neighbor. When taken to the obsessive extreme, however, envy arises when one subordinates the needs of the community to one’s own and, rather than trying to constructively adapt, becomes destructively jealous. Ironically, this behavior, while ostensibly committed to destroy the success of another, often prevents the success of the envious party. The instant gratification of ostentatiously outdoing one’s neighbor comes at the long-term cost of lost friendships.

Envy (in the investment world) – income (the misguided obsession to artificially inflate one’s current wealth at the expense of one’s future wealth.)

Albert Einstein may or may not have proclaimed “compound interest” as the most powerful force in the universe, but chances are your grandfather thought the idea of investing for income was the cat’s pajamas. He may have evened counseled you to buy a good long-term bond, spend the interest and never touch the principal.

But we come not to honor the quest for “income” but to bury it. Income, truth be told, is really irrelevant (except in the extremely rare case of self-endowment and split-interest trusts, which we shall address later). Knocking out one of the traditional investment goals (i.e., Income, Growth and Safety) appears the best way to start our journey through the Seven Deadly Sins. Of the Seven Deadly Sins, this one has the greatest general acceptance among professional money managers and even some grandfathers.

Rest assured, though, your grandfather wasn’t just being an old codger, he had centuries of tradition behind his sage advice. How many centuries? Think back to the days when it seemed like every word ended in the letter “e.” Why, ye can easily have heard such guidance in any olde shoppe ye may have come across. Come listen to the tale of yore we shall weave…

What do Robin Hood, Investment Income and Fiduciary Duty have in Common?

Some of you may be interested in the history of income as an investment objective. For this, we must take a short all-expense paid trip back to medieval Europe. The calendar says June 15, 1215 and you find yourself along the south bank of the Thames river in a placid meadow called Runnymede. Thirty six less than placid men have just witnessed the ignoble King John (you may know him as Prince John from the Robin Hood tale) affix his seal to several copies of parchment – the Magna Carta.

Just what does the Magna Carta have to do with income? Well, let’s take a peek at Section 5 of the British Library Board’s modern translation of that hastily written document (bold italics added for emphasis):

[5] Moreover, so long as he has the wardship of the land, the guardian shall keep in repair the houses, parks, preserves, ponds, mills and other things pertaining to the land out of the revenues from it; and he shall restore to the heir when he comes of age his land fully stocked with ploughs and the means of husbandry according to what the season of husbandry requires and the revenues of the land can reasonably bear.

It would seem, in feudal society, kings had, shall we say, certain “rights.” For example, in return for an oath of loyalty and obedience, including the duty to supply the king with military personnel (a.k.a. “knights”), the king granted land to the baron. The king still owned the land, but the baron got to use it and profit from anything he could reap from it. Over time, the baron’s decided it would be easier to pay cash in lieu of provided men. In doing so, kings like King John bought and paid for mercenaries.

But, with the cost of The Crusades, a run of terribly bad weather (some suggest it was caused by the Medieval Global Warming Period) and general mismanagement, King John found himself in need of petty cash (and then some). Fortunately for him, feudal custom also permitted the king to tax his barons in times of emergency. Moreover – and here’s where the fiduciary duty thing comes in – when a baron died, the king had the responsibility to run the estate until heir was of age. The king could collect all profits while the heir remained under age. In addition, the king had the right to sell his interest in the estate to anyone, including the right to sell the heir in marriage. He could also sell any individual assets, including the baron’s widow and any daughters. Of course, things were made simpler if there were no heirs to begin with. In such case, the king would inherit the entire estate. As Mel Brooks says in History of the World, Part I, “It’s good to be the king.”

Now, picture yourself a young landed squire about to march off to the Holy Land on behalf of your king and knowing the survival rate of such service was rather low. You look at your young wife and children, and you’re reminded of what King John has done to the heirs of your late peers. Worse, if you were lucky enough to come back, you’d certainly face usury taxes. These burdensome levies had already inspired a certain lad in Sherwood Forest to steal from John’s collectors and return the booty to their rightful owners. In fact, it turns out many of the other baron’s feel the same way you do.

Voilà! The Magna Carta. Backed in a corner, King John had no choice but to sign it or face a civil war. Granted, the King immediately appealed to Pope Innocent III (who abided and annulled the charter) while he brought in foreign mercenaries to fight the barons and all that real history stuff. Still, the Magna Carta remains not only the first series of codified laws (and, as a result, a direct predecessor of the U.S. Constitution), but also stands as the origin of trust and fiduciary law.

It also explains why income used to be so important. In feudal times, with the king essentially owning all the land (remember, the baron’s only “rented” it in return for loyalty, etc…), income represented the only true monetary value of property. Income would come in many flavors. First, it consisted primarily of agricultural products, but as the guild system grew, it could also mean actual rent. Despite the changing definition of income, property remained illiquid. As a result, the only option to protect one’s heirs meant creating a trust and thereby permitting the trustee to continue to farm (or whatever) the land to provide food (or whatever) to the heirs. The king (or the Church) would service a trustee and, as the principal beneficiaries or remaindermen of the trust, would ultimately inherit the land if and when the heir died. Therefore, the grantor of this split-interest trust (as well as his heirs) would focus on income. At the same time, as Section 5 of the Magna Carta asserts, the guardian had a fiduciary duty to maintain the property and “restore to the heir when he comes of age” the property as it was when the trustee first assumed his role.

Had this been the only reason to stress income, the idea would have evaporated long ago. Let’s continue our trip down memory lane by moving forward to the industrial revolution. Here we see the predominant form of government shift from a feudal monarchy to a (mostly) capitalist State. With civil courts replacing royal courts, we discover the State (i.e., the government) decided not all trustees were created equal, (some were really good, some were average and some were really bad). In its infinite wisdom, the State decided to enact a series of laws which would “protect the interests of all beneficiaries.” These laws “helped” trustees by telling the trustee what types of investments he would be allowed to invest in. The State, although on the cusp of the industrial revolution, continued to follow the traditional of the agricultural economy and emphasized income generating investments. Indeed, at first, investments emphasizing growth in principal were considered “too risky” (i.e., potentially harmful to the beneficiaries) for the staid conservative trusts. As a result, there became very very few, if any, really really good trustees, fewer really bad trustees and a whole lot of really average trustees.

Still, the income beneficiaries (i.e., currently living, breathing and voting people) were very very happy. About a generation or so later, however, the principal beneficiaries (i.e., people not living, breathing and voting when the laws were originally passed) figured out the single minded emphasis on income hurt them. Remember the inherent conflicts of the traditional investment goals (see “401k Plan Sponsors: Is Your Investment Policy Statement Still Using Outdated Language?” Fiduciary News, May 17, 2011).

Certainly, the inconsistency of the equity markets during the nineteenth century did justify the label “speculative” and stock investments may not have been suitable for practicing fiduciaries. But, this hurt really became apparent over time as inflation eroded the value of the original principal. Court rulings and new laws both permitted broader investments and made equities a safer investment. At first a trickle (i.e., some growth investments) were allowed. Today, nearly all states permit nearly any type of investment within a trust. Unfortunately, trust law still places a bias on income (although this is slowly evolving). In fact, archaic (i.e., older) trusts still require the trustee to hit certain income generating targets. Even some newer trusts are written which require the trustee to generate income. It’s a testament to the evolution of trust law that ERISA (which promulgated various forms of retirement trusts) does not contain any language specific to producing income for the beneficiaries.

What lessons do we learn from history?

Lesson #1: First, the importance of income derives from the agricultural economy. As we moved through the industrial age, service age and information age, the availability of liquid public equity has increased. Through this evolution, growth in principal has become a valid, if not universal, portfolio management discipline. In many cases, the reality of markets has moved faster than the sluggish laws. In fact, it’s quite apparent legislated investment policies are often outdated before they are even signed into law.

Lesson #2: Indeed, since the Securities Laws and other investment acts of the depression era, we’ve seen government imperatives sometimes require fiduciaries to violate investment fundamentals. For example, if the Department of Labor “requires” plan sponsors to select only the least expensive investment option, fiduciaries are in danger of limiting choices only to index funds, even though research suggests certain actively managed portfolios (i.e., no-load mutual funds) may yield better long term results for retirement investors. This is similar to post-WWII (mostly state) trust law that requires trusts to invest only in bonds.

Lesson #3: Finally, and court cases from the late 1800’s through today imply Lesson #2 does not prevent the fiduciary from getting sued even when following the law.

Part I: What do Robin Hood, Investment Income and Fiduciary Duty have in Common?
Part II: Plan Sponsor Warning: What’s Wrong with Emphasizing Income?
Part III: Is Income Really the Only Way for a 401k Fiduciary to Meet Certain Investment Objectives?
Part IV: If Income Doesn’t Matter, What Should Plan Sponsors Look For?
Part V: How the ERISA Fiduciary Can Avoid the 1^st Deadly Sin – Whither “Time Diversification?”