Litigation Over 401(K) Costs and Disclosure Could Become Prevalent

Over a year ago, we predicted a wave of litigation against 401(k) sponsors based on their failure to investigate and prudently minimize costs charged to plan participants. Our article predicted (i) lawsuits based on the employer’s fiduciary duty to act for the exclusive benefit of the plan’s participants, and (ii) claims for failing to disclose all costs charged to participants, excessive fees, and fiduciary conflicts of interest.

Our prediction has begun to occur. Nine lawsuits were recently filed against some of the country’s largest employers in federal courts in California, Illinois, Connecticut, and Missouri. The suits are based on the broad fiduciary duties specified in the Employee Retirement Income Security Act of 1974 (ERISA) – specifically sections 502(a)(2) and 502(a)(3). The employers sued are Bechtel, Caterpillar, Exelon, General Dynamics, International Paper, Lockheed Martin, Northrop Grumman, and United Technologies.

The damages in these lawsuits can be staggering. Amounts invested in 401(k) plans in the U.S. currently total over $3 trillion. There are numerous illustrations by various financial service firms regarding the huge impact of additional investment costs fees over one’s career, with each employee’s losses generally ranging from a quarter million to three quarters of a million dollars, depending upon the illustration’s inputs. Even if the loss per employee were substantially less, a claim of $100,000 per employee would be devastating to practically any employer (e.g., $100,000 times 100 employees equals $10 million).

Lawyers for plan sponsors should advise their clients to investigate the costs their plans are charged, and to make sound judgments regarding whether value is received for what plan participants are paying. Employers of all sizes should see these lawsuits as a wake-up call to negotiate different arrangements, and/or make changes in the investments offered participants if the fees are not warranted by what is being received. The entire process should be documented.

 What are the common problems?

401(k) plans are rapidly replacing traditional pension plans. In a traditional pension plan (aka defined benefit plan), employers pay a fixed amount based on a formula contained in the plan. Employers with pension plans have an incentive to manage costs. But in a 401(k) plan, employees receive only the value in their personal account. In this situation, employers do not have the same incentive to watch the costs that are paid by the employees.

Plan fiduciaries need to follow a prudent process in selecting investment alternatives and disclosing what the costs are. Here are common problems that smart employers should proactively address:

1. Revenue sharing deals are usually not disclosed. In a revenue sharing arrangement, the mutual fund company kicks back a portion of its fees to the salesperson who advises the plan on what investments to select. The conflict of interest is obvious.

2. In disclosures given to plan participants, some mutual funds claim that their portfolios are actively managed. For this active management, the mutual fund charges fees that are several times higher than would occur with passive investment management using an index fund. Yet, using statistical analysis, it can be shown that the mutual funds actually are closet index funds, in that their returns are consistently not any different than are achieved using cheaper index funds. If the investment results are consistently not any different from a cheaper index fund, the higher cost fund should be eliminated from the investment selection.

3. For larger employers that have multiple plans run through master trusts, the costs that are paid by the central trusts should also be disclosed.

Section 404(c) not a safe harbor.

Many plan sponsors falsely believe that ERISA Section 404(c) provides protection against these claims; it does not. Section 404(c) shields fiduciaries from investment losses caused by employee decisions if certain requirements are met. However, Section 404(c) does nothing to reduce exposure for:

1. The original selection of investment alternatives

2. A failure to reduce costs paid by participants

3. The duty to keep participants’ best interests in the forefront of every decision

Because of these Section 404(c) limitations, plan sponsors are not protected against claims of lost opportunity relating to costs.

Regulators are starting to admit the problem.

Last month, the Department of Labor (DOL) said it would propose new rules that would require plan sponsors to disclose additional information about plan costs. In testimony before the DOL advisory panel last month, industry representatives admitted that change is needed. Some examples:

1. The Investment Company Institute (the mutual fund’s chief trade group) agreed that (i) there were often “significant gaps” in the disclosure given to 401(k) investors, and (ii) basic information about fees and investment performance was often not received.

2. The Employee Fiduciary Corp (a 401(k) recordkeeping and administration firm) said, “Real fee disclosure is lacking in many ways. … While a professional who spends hours can learn what the fees are, the typical employer and employee have no idea what they are being charged.”

This area deserves greater focus by plans of all sizes. Although the current cases are aimed at large employers, similar cases are likely against smaller employers, who are less likely to spend the time to negotiate reasonable fees. Consequently, fees paid by smaller plans, especially those holding insurance-based products, have proportionally higher fees.

Fulcrum Inquiry is a registered investment advisory firm.  We also perform financial investigations business and intangible asset appraisals, and assist lawyers in financial aspects of litigation