We read about lawsuits brought against plan sponsors with increasing regularity. As one reads the stories trends begin to emerge regarding the causes of these lawsuits. This month, the Center for Retirement Research at Boston College released a study documenting the causes and consequences of 401(k) lawsuits. With over 100 new 401(k) related complaints filed in 2016-2017, this is a topic on most plan advisors radars.
As plan sponsors, advisors, and now even record-keepers, are trying to comply with government regulations, the challenge comes in complying with regulations that in many key regards lack detail or definition. As the report puts it, “instead of laying out specific regulations or guidance, the Department of Labor’s (DOL) general approach to overseeing 401(k)s has been through its own enforcement actions or through litigation (mostly privately initiated).” It behooves advisors to keep abreast of these lawsuits to get an idea of how the DOL and the courts will choose to enforce the law.
The report identified the three most common reasons for litigation: 1) inappropriate investment options, 2) excessive fees, and 3) self-dealing.
Inappropriate Investment Options
Historically, the biggest reason for complaints was inappropriate investment options. From 2007 to 2012, inappropriate investment option complaints made up an overwhelming majority of all complaints. The law does not provide any details or guidelines about what types of investment are appropriate or how to select or monitor these investments. In lieu of details, ERISA instructs fiduciaries to exercise “’the care, skill, prudence, and diligence … that a prudent man’ would when choosing investments ‘so as to minimize the risk of large losses.’” What this seems to imply, and what courts have emphasized, is that the process of investment selection is of the utmost importance.
Indeed, two different fiduciaries with the same investment selection may face different levels of liability depending on the process they used to select the investments. Some recent lawsuits have focused on selecting funds that have consistently underperformed the indexes they are benchmarked against or selecting funds without adequate performance history.
A related complaint that has seen sharp increases from 2014 onward is the complaint of excessive fees. This is now the most cited reason for litigation and many advisors will have read about related cases in the news. Excessive fee complaints can center on investment fees, administrative fees, or both and are often combined with other complaints in a lawsuit.
Investment fee complaints are usually related to expense ratios and advisors can find encouragement in some of the courts’ rulings in these cases. While the law does not define what a “reasonable fee” is, courts have rules that reasonable does not necessarily mean the cheapest not that that fees for actively-managed funds need be benchmarked to passively-managed funds. The key seems to be whether they are reasonable compared to similar funds.
Another key component, as far as how the courts interpret the law, is that the plan is offering the lowest-cost version of the fund. For example, a plan offering a fund in a retail share class when a cheaper institution share class is available may find that they will run afoul of the courts.
Complaints of excessive administrative fees are typically brought when the fiduciary has failed to follow a process for evaluating these fees against other plans, negotiate better fees or generally fail to monitor the fees associated with their plans.
Again, the key to these excessing investment and administrative fee lawsuits seems to revolve around having a good process for evaluating and monitoring fees and doing the best to keep these fees at a reasonable level.
In terms of 401(k) litigation, self-dealing complaints normally allege that the fiduciary or plan sponsor has not acted solely in the best interests of the plan participants but has put its own best interest above that of the participants. The largest target for these lawsuits are financial services firms. On recent years over 40 financial services firms have been involved in self-dealing lawsuits because they have offered proprietary funds in their investment line-up, funds which plaintiffs allege had poor or inadequate performance, excessive fees, or both.
With the resurgence of 401(k) litigation and trends outlined above, particularly in regard to investment options and fees, the report highlights trends in how fiduciaries have responded to avoid litigation.
One response has been a greater reliance on passive investment options, even though courts have held that actively-managed funds can be appropriate investment options. With lower fees and minimized risk of underperforming a benchmark, passive funds are seen as a safe choice, at the expense of the potentially higher gains of actively-managed funds.
Another trend in fiduciary response has been to reduce the number and type of investment option offered. Given the lack of participant knowledge, many fiduciaries have cut industry specific funds, commodity funds and fixed income options from the plan to avoid potential litigation.
Greater fee transparency has also been a by-product of the increased litigation. As more lawsuits focus on excessive fees, fiduciaries are demanding greater fee transparency and clearer benchmarking for both investment and administrative fees.
Given the lack of clarity in the law and precedents set by the courts, it seems that the most important take-away for advisors is that they develop and sound process and perform good due diligence for evaluating and selecting investment options and administrators. Fiduciaries who have followed a well –defined process seem to have fared better in the courts being better able to justify and defend their action on the plan.
Disclaimer: For more detail, please reference the full report. RetireReady Solutions is a software provider, not a lawyer and this post should not been taken as legal advice but merely a summary of and commentary on the research performed by the Boston College Center for Retirement Research.