Retirement Plans

Passive Aggression

Why 401(k) plan sponsors' motivations for switching to passive investment vehicles could run afoul of ERISA.
David McCannJune 22, 2016
Passive Aggression

For 401(k) plan sponsors, the risk of being sued is once again on the rise. Over the past year, plan participants have filed class actions against companies like Verizon Communications, Intel, Chevron, and BB&T over high fees or poor performance. Not surprisingly, some plan sponsors are switching from active funds to index funds and other passive investment vehicles, which generally offer low fees and bring higher returns than many active funds.

According to a 2015 study of 254 plan sponsors by Aon Hewitt, 36% said they were “moderately” or “very” likely to switch some or all of their actively managed funds to index funds in 2016.

A Better Way to Do Ecommerce

A Better Way to Do Ecommerce

Learn how Precision Medical leveraged OneWorld to cut the cost of billing in half and added $2.5M in annual revenue.

That would accelerate a trend that’s been unfolding for years. At the close of Q1 2016, 49% of assets in target-date funds within 401(k) plans were passively managed, according to Mercer’s quarterly TDF survey, up from 36% five years earlier. That’s particularly notable considering that TDFs are drawing the bulk of new inflows into 401(k) plans. Among employees hired within the previous two years, 59% of their balances were invested in TDFs at the end of 2014, the most recent year studied by the Employee Benefit Research Institute.

The move toward more passive investment options in 401(k) plans is even more pronounced than the increasing popularity of such vehicles for all investors. At the end of May, 33% of all assets in U.S. mutual funds and exchange-traded funds combined were invested in passive vehicles like index-based funds, according to Morningstar. At year-end 2010, that figure was 23%. (See chart.)

But back to plan sponsors: If they are moving to passive investments primarily to forestall litigation, they could be courting more lawsuits, experts warn. That’s because if participants’ best interests are not the top motivation for shifting investment strategies, sponsors may not be properly exercising their fiduciary duties.

The Employee Retirement Income Security Act of 1974 (ERISA) requires that plan fiduciaries solely take into account the best interests of participants and beneficiaries when making decisions about retirement plans (except decisions such as whether to have a plan or cancel an existing one).

But it appears that more often than not, fiduciaries don’t adhere to the rule. In a recent survey of 410 large 401(k) plan sponsors, 57% told Cerulli Associates that the primary reason they decided to offer passively managed investment options was to “alleviate threat of lawsuits/fiduciary concerns.” Similarly, 55.3% of respondents identified “fiduciary liability and fear of lawsuits” as a very important factor when making decisions regarding 401(k) plans.

“Someone who has a clear view of what their fiduciary obligations are can’t respond to a survey saying they’re making decisions in a fiduciary capacity to protect themselves or their company from liability,” says Jamie Fleckner, a partner with law firm Goodwin Procter.

Jessica Sclafani, associate director of Cerulli’s retirement practice, agrees, adding: “There’s an increased interest in passive investing because plan sponsors mistakenly believe it mitigates their fiduciary exposure. Nothing in ERISA says you are protected by offering passive investments.”

A History of Litigation
That’s not to say plan sponsors don’t have legitimate legal concerns. In the 15 years since the implosion of Enron decimated its employees’ retirement accounts, which were heavy with Enron stock, plan participants have brought hundreds of lawsuits against sponsors of large retirement plans.

For many years, most such cases were against companies that either offered company stock, which performed poorly, as the only investment option in the plan, or that were alleged in one way or another to have misled or coerced plan participants into buying company stock, following which the stock lost value.

Around 2007, cases began appearing that charged plan sponsors with lack of prudent plan management by selecting funds carrying higher administrative fees than other comparable options. Just in the past two years, and increasingly so recently, the number of such suits has spiked, and the mix of suits “has tilted more toward the fee suits,” says Fleckner.

That’s happening for a couple of reasons, Fleckner notes. For one, the Supreme Court last year ruled in a case against utility Edison International that after a fund is selected, a fiduciary has an ongoing duty to monitor plan investments in it, including fees. Previously, courts threw out many fee cases involving investment options that had been available in plans for longer than the six-year statute of limitations for damages claims that is stipulated in federal law.

For another, some high-profile fee lawsuits have been settled for big money. For example, in 2015, Lockheed Martin and Boeing settled such cases for $62 million and $57 million, respectively. That has pushed plaintiffs’ attorneys to more aggressively target large plans. Fleckner says the trend is disturbing, and not just because it’s causing plan sponsors to base plan decisions on inappropriate motivations.

“Litigation is not an efficient way to regulate an industry,” Fleckner says. “Each case is very idiosyncratic to particular facts, particular evidence, and maybe to the parties, the lawyers, and the judges.”

On the other hand, there likely would be many more fee suits, specifically targeting smaller plans, if the economics of such cases were attractive to plaintiffs’ attorneys. Charles Massimo, CEO of CJM Wealth Management, says fiduciaries at the vast majority of 401(k) plans that the firm reviews are in breach of their responsibilities under ERISA.

The most common issue, Massimo says, is related to which “share classes” a plan’s funds are in. Essentially, share classes are multiple versions of the same fund, the only difference being the administrative fees, which are highest for individual investors and lowest for large institutional ones. “Most fiduciaries don’t realize there can be seven different share classes for a fund,” Massimo says. “The majority of plans we see have funds in more expensive share classes when they’re eligible for a lower-cost share class.”

Focus on Costs
In most cases, plan sponsors are not replacing actively managed funds with passive ones. Rather, they’re adding a “sleeve” of passive funds to the lineup to provide a low-cost, index-based investment choice in each major asset class category, as well as an actively managed option in each category, says Liana Magner, leader of U.S. direct contribution investment for Mercer Investments.

Some are taking the more radical approach, though. “We are seeing many plan sponsors eliminating all active management,” says Josh Cohen, managing director and head of institutional defined contribution at Russell Investments. “And in many cases, they are moving to the lowest cost possible.”

Bradford Campbell, an of-counsel attorney with Drinker Biddle & Reath, points out that ERISA doesn’t require plan sponsors to pick the lowest-cost options. It requires them merely to ensure that fees be “reasonable.”

“However, the [specter of potential lawsuits] has definitely influenced how plan committees have been looking at investments and made them focus more on costs,” says Campbell, who served as assistant secretary of labor for employee benefits during the second George W. Bush administration.

16Jul_SR_Quote“If they pick the lowest cost,” Campbell continues, “they view it as reducing their litigation risk, even though it isn’t necessarily the case that a lowest-cost fund is the most prudent one. An investment committee might actually think that a mix of active and passive investments is best, but do they really want to defend the extra cost of litigation? So they just decide to offer a diversified suite of passive investments.”

He suggests, though, that a literal interpretation of “acting solely in participants’ interests” may not be necessary in practical terms. What matters more, from an enforcement standpoint, is a written record of motivations for decisions.

If the notes of a plan committee meeting say, “Because we are afraid of litigation, we will dump all of our active funds,” that could well be viewed as a violation of ERISA, Campbell says. But if the notes say, “We’ve concluded that fees are an important part of this decision, and on balance we’ve decided that our participants will be better served by lower-cost investments,” it would be difficult for regulators to demonstrate that it was an imprudent decision, according to Campbell.

Still, Magner cautions plan sponsors that even with passive investment options, there are important decisions to be made for which plan fiduciaries can be held accountable.

“You’re still on the hook for making sure you’re in the best vehicle for your asset base,” she says. “And there are passive strategies out there that have revenue sharing built into them and have higher fees than we would like to see.”